Fundamental Analysis

How to buy shares with fundamental analysis

Theory

Fundamental analysis assesses a share’s value in terms of its economic, financial and sector performance. This value helps to support a decision to buy or sell it. Fundamental analysis is based on the premise that good quality companies have:

increasing revenue growth
increasing profits
long-term prospects for their products and services
a favoured industrial sector

Good quality companies are highly favoured by investors in the expectation that they’ll continue to produce long term share price growth. The strategy is used extensively by professional fund managers. However share prices often move in a contrary way to the view expressed by investment analysts. In particular, the method performs very badly in stock market crashes and reactions to sudden disasters eg BP’s gulf rig explosion.

1. Economic Analysis

The process starts by assessing the state of the economy. The investment analyst would examine various factors - such as GDP (Gross Domestic Product), stock market indices, inflation rate, interest rate, consumer spending, trade balance of imports vs. exports and political stability. In a boom period, the analyst will take the view that the prospects for the stock market are good and conditions support investment in shares. In a depression, the analyst often states that conditions are appropriate for investment because stocks are cheap. They represent good value for money and should recover in the long term.

2. Sector Analysis

Stocks are classified into industrial sectors - such as banks, engineering, food, consumer goods, leisure, pharmaceuticals, mining, utilities etc. There are about 20 sectors and, as a rule of thumb, the difference in growth between the best and the worst performing sectors is approximately 100%pa. You can find them in the financial press and on websites.

In a depression, sectors such as food and utilities are favoured more than leisure and consumer goods - because people always need to eat and drink and consume power and water but they always cut back on consumer and leisure items to save money. During boom conditions, people will spend more on consumer items and leisure. Thus sectors can rapidly become overheated as demand soars and the media reports on exciting new products, like the boom period leading up to the dot-com crash. Conversely bad financial news can lead to a rapid decline and banking sector shares can crash.

3. Company Analysis

The analyst assesses the company by studying the company's interim and annual accounts. In Britain, interim accounts are published after 6 months and the annual accounts at year end. In North America, companies publish quarterly figures. The analyst looks at key accounting ratios, gross and net profit, stock turnover, profit margins, cash flow, price earnings ratio (P/E), earnings per share (EPS), revenue growth and management statements. Companies with strong profit growth and good future prospects are more likely to support a continual rising share price.

4. Share Price Analysis

Although there are some mathematical formulae which attempt to value a share, most analysts use subjective methods to decide whether a stock is overvalued (to sell it) or undervalued (to buy it). They look at recent company announcements and TV news - as well as research reports from major investment houses. Take for example BP, one of the largest companies in the FTSE100 and a highly regarded profitable business. Then suddenly in April 2010, it announces the loss of its rig, Deepwater Horizon, in the Gulf of Mexico and its share price falls 50% in 50 days. Similarly, stocks can be subject to meteoric rises in share price - such as the dot.com boom in 1999-2000.

Trading Strategy

Fundamental analysis promotes the strategy that stocks need to be held for the long-term and that steadily rising profits equates to rising share prices. The fundamental analysis method involves four stages: