Understanding Stock Fundamentals: Key Metrics and Analysis

What Are Stock Fundamentals?

Stock fundamentals are the key metrics that reveal a company’s financial health, such as cash flow, return on assets (ROA), and profitability. Fundamental analysis uses these metrics to evaluate a stock’s true value and identify the data points most likely to influence its price. By understanding stock fundamentals, investors can make more informed decisions, choosing investments based on solid financial insights rather than speculation.

Understanding the Mechanics of Stock Fundamentals

In the broadest terms, fundamental analysis involves looking at any data that is expected to impact the price or perceived value of a stock. This is, of course, anything aside from the stock's trading patterns. As the name implies, it means getting down to basics.

Fundamental analysis focuses on creating a company portrait, identifying its shares' fundamental value, and buying or selling the stock based on that information. Some of the indicators commonly used to assess company fundamentals include:

• Cash flow
• Return on assets
• Conservative gearing
• History of profit retention for funding future growth
• The soundness of capital management for the maximization of shareholder earnings and returns

Fundamental analysts have a staid approach to analyzing stock performance. They look at a variety of factors that they believe influence a stock's performance. These include the industry as a whole, the competition, a company's management structure, its income and revenue, as well as its growth potential.

Real-World Application of Stock Fundamentals

All of the data is public and readily available, generally through a company's financial statements. The goal is to identify which stocks are priced correctly—and incorrectly—by the market.

To help you visualize it, let's use the following analogy. Think of the stock market as a shopping mall, where stocks are the items for sale in the retail outlets. Their sights are set solely on the products in the mall. Shoppers are dismissed as unreliable, emotional herds with no inkling of the real value of the goods for sale.

Fundamental analysts move slowly through the stores seeking the best deals. Once the crowd moves on from, say, the personal computers (PCs), they will take a closer look at the ones that were passed over.

Fundamental analysts may take a stab at determining the scrap value of the PC stripped down to its hard disk, memory cards, monitor, and keyboard. In the stock market, this is akin to calculating the book value, or liquidation price, of a company.

These analysts also take a very close look at the quality of the PC. Is it going to last or will it break down within a year? The fundamental analysts will pore over the specifications, scrutinize the manufacturer's warranty, and consult consumer reports. Similarly, equity analysts check a company's balance sheet for financial stability.

Then, the fundamental analysts may try to understand the PC's performance in terms of, say, processing power, memory, or image resolution. These are like the forecast earnings and dividends identified from a company's income statement.

Finally, the fundamental analysts will put together all the data and come up with the intrinsic value, or value independent of the current sale price. If the sale price is less than the calculated intrinsic value, the fundamentalists will buy PCs. If not, they will either sell the PCs they already own or wait for prices to fall before buying more.

Important Considerations When Analyzing Stock Fundamentals

Performing fundamental analysis can be a lot of work, but that is arguably the source of its appeal. By digging into a company's financial statements and assessing its future prospects, investors can learn enough to know when the stock price is wrong.

These conscientious investors can spot the market's mistakes and make themselves money. At the same time, buying companies based on intrinsic, long-term value protects investors from the dangers of day-to-day market fluctuations.

However, the fact that fundamental analysis shows that a stock is undervalued does not guarantee it will trade at its intrinsic value any time soon. Things are not so simple. In reality, real share price behavior relentlessly calls into question almost every stock holding, and even the most independently-minded investor can start doubting the merits of fundamental analysis. There is no magic formula for figuring out intrinsic value.

When the stock market is booming, it is easy for investors to fool themselves into thinking they have a knack for picking winners. But when the market falls and the outlook is uncertain, investors cannot rely on luck. They actually need to know what they're doing.

Comparing Fundamental and Technical Analysis Techniques

Fundamental analysis is much different from its cousin, technical analysis. Where fundamental analysis focuses on measuring a stock's intrinsic value, technical analysis concentrates solely on the trading and price history of a stock by looking at trading signals and other analytical tools to evaluate the strength or weakness of a stock.

Technical analysts believe that a stock's past performance—its price and trading activity—can help determine where it will go in the future. In essence, the theory of technical analysis is rooted in the fact that the movement in price is not random. Instead, it believes that patterns and trends are identifiable and repeat over time.

To demonstrate, let's go back to the analogy above. Technical analysts ignore the goods for sale. Instead, they keep an eye on the crowds as a guide for what to buy. So, if a technical analyst notices shoppers congregating inside a computer shop, they will try to buy as many PCs as possible, betting that the growing demand will push PC prices higher.

The Bottom Line

Fundamental analysis involves evaluating key stock metrics to estimate a company’s intrinsic value. The goal is to identify stocks that may be undervalued in the market. Investors like Warren Buffett often use this approach to guide their decisions, seeking opportunities where a company’s true value exceeds its current market price.

The comments, opinions, and analyses expressed on Investopedia are for informational purposes only. Read our warranty and liability disclaimer for more info.