How to Use Fundamental Analysis to Pick Stocks

If you’re new to the investment arena, you’ve likely come across the concept strong fundamentals. Passing reference to this means precious little if it is not explained in its entirety. Fundamental analysis provides an excellent way to evaluate the viability of an investment.  The goal of course is to identify the intrinsic value of a stock – its true worth. This intrinsic value differs from the market value that the stock is currently being traded at. If the intrinsic value is greater than the share price then it makes sense to purchase the stock. Fundamental analysis can help you to do precisely that – discover the intrinsic value of stocks. The concept of discounted cash flows comes into play to make this evaluation possible.

Fundamental Analysis in Action

The net worth of a company is the sum total of all discounted cash flows. Simply put, this means that any company or enterprise is valued at the sum total of its future profits which are then discounted according to the time value of money. Money received today has a greater real value than that same nominal figure received at a future point in time. Another indisputable reality is that stock prices do not represent intrinsic values of companies. Stock prices reflect market sentiment which is as fickle as the people making investment decisions. Stocks are considered trading vehicles, and a notion has come to pass known as Greater Fool Theory. This simply means that the intrinsic value is not taken into account when speculators sell stocks to fools who believe this or that.

Projections and Speculation with Regards to Intrinsic Value

Technical analysis relies on observance of market trends, as reflected in financial charts. Fundamental analysis centres on intrinsic value. Neither approach should be adopted in place of the other; rather a combination of both approaches should be used to generate profits in the stock markets. The consensus is that fundamental analysis bodes well for long-term investments while technical analysis has gained the favour of short-term investment strategists. Future cash flows are difficult to anticipate, but necessary for effective fundamental analysis. A point of departure is to determine the timeframe for the projection. A figure of 5 years, or 10 years is commonplace. There are many uncertainties to consider, including the possibility that company ownership may change, companies may close down, and market volatility may render a company defunct. That is why probabilities come into play when devising a strategy for discounted cash flows.

In-Depth Analysis of Company Stocks Necessary for Fundamental Analysis

Companies go through different stages of growth, development and possible decline. All of these factors have to be built into the fundamental analysis when predicting future cash flows. Assumptions are based on prior year cash flow, growth rate, cash flow, discount factor, discount value per year and so forth. The intrinsic value of a company takes into account all future cash flows, valuations and discount factors to arrive at a figure that investors may or may not bite at. The bottom line is that cash flow comprises the most important component of fundamental analysis. By predicting/anticipating what possibilities exist, dividends can be measured. There are all manner of valuations that are possible including free cash flow, net income and EBITDA. Naturally there are inherent advantages and disadvantages when using metrics of any kind. Intrinsic value however is the number one consideration with respect to fundamental analysis in stocks.

About the author: Brett Chatz is a graduate of the University of South Africa, and holds a Bachelor of Commerce degree, with Economics and Strategic management as his major subjects. Nowadays Brett contributes informative essays for the globally renowned spread betting and CFD trading provider, InterTrader.com.