Fundamental analysis is one of the most popular ways of determining the value of a stock. Think of fundamental analysis as like like determining the value of a cricketer by looking at his averages, strike rates and economy rates. By looking up the past averages of batsmen, you can draw a reasonable analysis of how they’ll perform in a future game. By checking out the economy rates of bowlers, you can reasonably predict how expensive they will be. Similarly, fundamental analysis looks at the numbers behind companies, and uses it to predict their future performance.
The numbers around companies are many and varied, and we’ll go through them in greater detail in later posts. The most basics are revenues, which is the total money earned by the firm; the expenses, which is the total money spent by the company, and the profit or loss, which is the difference between the revenues and the expenses. Now just like the average of a batsman is the total number of runs scored divided by the number of dismissals, there are several other ratio created out of these numbers. We’ll go through them in greater detail going forward.
Fundamental analysis provides a great way of comparing companies. Just like comparing the averages of two batsmen gives an idea of who the better player is, comparing the company numbers of two comparable companies gives an idea of which the better companies. If there are two companies, A and B, which make tyres, and A’s profits have been consistently greater than B’s over the last few years, it means that A’s stock should be more valuable than B’s, and will likely rise going forward.
The Why Not
But just as though prior performances don’t really guarantee future performances — a batsman with a high average can perform poorly in a particular match, and even have an extended run of form — fundamental analysis isn’t a foolproof method to predict stock prices. Also, numbers alone can’t capture several factors that are inherent at companies, such as the quality of the management, and the morale of its workers.
But as soon you’ll realize, no one method can perfectly predict stock prices. Fundamental analysis forms a great part of a stock picker’s arsenal to determine which stocks to buy. It’s easy to understand, it’s deterministic, and it allows some great comparison between peer companies. We’ll learn more about it in the coming posts.