Applying fundamental analysis to make rational investment decisions

For many new investors entering the stock market for the first time, it is common for us to be unsure of what stocks to invest in. We could end up buying a stock just because of the hype or through word-of-mouth. However, this could be a dangerous approach and in fact, I would liken it to gambling as we are just purely speculating on future stock prices without any backing to support our decision.

One approach to making more well-informed investment decisions is through applying fundamental analysis. Personally, I feel that it is an effective way to determine the intrinsic or true value of a particular company’s share price. It gives us an inkling of the long-term value of the business. If you are unsure of what fundamental analysis entails, allow me to break it down for you.

1. Analyse where the economy is headed towards

The first step is to get an overall picture of the economy. Is the economy heading towards an expansion or recession? What should we do in each of these scenarios? These are questions that we must ask ourselves to determine the risk of our investments. To get a rough gauge of the health of the economy, we can gather data from sources such as the US Consumer Confidence Index (CCI). We can also look at certain indicators such as inflation and interest rate levels to determine the kind of asset classes we should invest in. In periods of high interest rates, bond prices generally fall, and bond yields tend to increase. In contrast, stock prices generally fall when interest rates rise. Thus, it is crucial to understand the impact of changes in economic indicators on the different asset classes.

2. Analyse the potential of the industry

After looking at the economy, let us dive deeper into industry analysis. Based on recent news and the latest trends, we can classify the different industries into two groups, sunset and sunrise. Sunset industries are industries that are slowly becoming obsolete, possibly due to failure to keep up with rising technological innovations or losing their demand to more relevant industries. On the contrary, sunrise industries are emerging industries that have huge growth potential and are expected to be the ‘in thing’ in the near future. For example, with increasing concerns over sustainability, we are witnessing a gradual shift towards the electric vehicle industry from the traditional fuel-powered car industry. This serves as a guide for us to invest in profitable industries that have high growth potential.

Furthermore, government laws such as tariffs, bans, or restrictions on certain industries that are deemed to be undesirable may also increase the cost of production within such industries, leading to higher costs and lower profit margins.

3. Analyse the quantitative and qualitative aspects of the company

Having identified the industries with high growth potential, we can finally narrow down on individual companies. To analyse different companies, we can adopt both quantitative and qualitative methods.

For quantitative analysis, we can look at the company's financial statements to gauge its financial health. We can locate the financial statements in the annual reports published by the respective companies. For investors like us, we can narrow down on a few key ratios such as Earnings Per Share (EPS), Return on Equity (ROE), Price-to-Earnings (P/E), Price-to-Book (P/B), Debt to Equity (D/E), and Quick ratio. These ratios can give us a general idea of the company’s profitability, solvency, and liquidity. Comparing the ratios of one company with other companies in the same industry also allows us to see how it generally fares among all its competitors. Though these ratios can be very useful, relying on these ratios alone will not provide us with a complete understanding of the company’s prospects. We need to back these ratios up with other qualitative analysis to make more rational investment decisions.

Source: Financial Ratios (wallstreetmojo.com)

For qualitative analysis, one area we can look at is the management team. It is important to identify the personnel making the key decisions for the company. Do they have a good track record? Did those businesses that they previously led succeed? These are some questions that we can ask ourselves when looking at the leaders of a company. After all, investors want honest, transparent, competent, and reliable leaders that can maximise shareholders’ value.

Another area we can look at is the business model of the company. Where is the business deriving its revenue from? How large is their customer base? Are the business practices sustainable in the long run and aligned with future trends? Having a well-thought-out business model is crucial as it determines the long-term relevance of the company. Investors are also generally attracted to businesses that possess a competitive advantage over their competitors as it could translate to lower costs and higher profits.

All that being said, fundamental analysis is not perfect, and it is based on several assumptions as well. Quantitative analysis of the financial figures often relies on the assumption that the information provided by the company is true and provides an accurate representation. It also assumes that some of these fundamental factors being analysed have yet to be priced in by the market and the stock is currently overvalued or undervalued.

To end off, fundamental analysis is one useful method to assist us in making rational investment decisions, the other being technical analysis. Fundamental analysis is a very comprehensive process, requiring plenty of time and effort to carefully interpret information. However, I believe that performing our due diligence is of utmost importance in investing. I believe that our thorough research and analysis will eventually pay off in the long run when the company’s stock price adjusts to reflect its fundamentals.

Disclaimer: The opinions expressed in this article are based on my personal experience applying fundamental analysis and solely for educational purposes only. It does not constitute financial advice and I will not be held responsible for any investment losses resulting from applying this strategy. Always do your own due diligence before making any investment decision.