If you want to invest like the greatest investor of all time, Warren Buffett, fundamental analysis will be an important tool for you to use.
So you've got some money saved and you want to invest it in the stock market. Good choice. Over time the stock market has returned an average of 11% on invested capital.
As an investor, you have many tools at hand to help you on your quest. One of the most useful of these tools is fundamental analysis – examining key ratios which show the worth of a stock and how a company is performing (this is a primary methods of Warren Buffet, the second richest man in America).
This method is very different from another method called technical analysis. Technical analysis analyzes the movement of stock prices and daily trading volume. Instead of looking at the companies on the exchange, you are watching how the people buying and selling stock are acting on a day by day basis. That's quite different from the use of fundamental analysis.
The goal of fundamental analysis is to determine how much money a company is making at present and what kind of earnings can be expected in the future. Although future earnings are always subject to interpretation, a good earning history creates confidence among investors. Through good earnings, stock prices increase and dividends may also be paid out.
Where does Fundamental Analysis begin?
Companies are required to report earnings on a regular basis and stock market analysts examine these figures to determine if a company is meeting its expected growth. If not, there is usually a downturn in the stock's price.
There are many tools available to help determine a company's earnings and its value on the stock market. Most of them rely on the financial statements provided by the company. Further fundamental analysis can be done to reveal details about the value of a company including its competitive advantages and the ratio of ownership between management and outside investors. All the figures can be confusing, but if you learn how to do it, it can be invaluable in how you invest your money.
Financial Statements
Every publicly traded company is required to publish regular financial statements. These statements are available in printed form or on the Internet. All statements must include an income statement, a balance sheet, an auditor's report, a statement of cash flow, a description of the business activities and the expected revenue for the coming year.
Auditor's Report
The auditor's report is one of the most important sections of the financial statement. The auditor is an independent Certified Public Accountant firm which examines the company's financial activities to determine if the financial statement is an accurate description of the earnings. The auditor's report contains the opinion of the auditor concerning the accuracy of the financial statement. A financial statement without an independent auditor's report is essentially worthless because it could contain misleading or inaccurate information. An auditor's report, although not a guarantee of accuracy, at least provides credibility to the financial statement.
Balance Sheet
Another important section of the financial statement is the balance sheet. This is a 'snapshot' as it were, of the financial condition of the company at a single point in time. The balance sheet shows the relationship between assets (cash, property and equipment), liabilities (debt) and equity (retained earnings and stock).
Income Statement
The income statement shows information about the revenue, net income, and earnings per share over a period of time. The top line of the income statement shows the amount of income generated by sales, underneath which the costs incurred in doing business are deducted. The bottom line show the net income (or loss) and the income per share.
Cash Flow
The statement of cash flow is similar to the income statement – it provides a picture of a company's performance over time. The cash flow statement, however, does not use accounting procedures such as depreciation – it is simply an indicator of how a company handles income and expenses. A statement of cash flow shows levels of incoming and outgoing cash from sales, investments, and financing. It is a good indicator about how the company is run on a day-to-day basis, how it handles creditors and from where it receives growth capital.
Once you've found a business run well, making money, you then wait until it is undervalued. From time to time investors get rattled and the market goes down more than it should. Yes there are people who believe that the market is efficient and you can't find irrational values. That's not what Warren Buffet believes. He says, "I'd be a bum on the street with a tin cup if the markets were always efficient."
The key is to be ready to invest when the markets go down irrationally. That emotion will carry good stocks down with it. That is when you buy... good stocks. It sure beats trying to invest using some hot stock market pick suggested by a co-worker or relative. If you're going to buy stocks, buy smart.
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