Why Fundamental Analysis Matters

A stock’s price can swing day by day based on headlines, but over long stretches, it tends to follow how a company actually performs.

Knowing how to read the company data behind a stock’s performance helps you avoid paying $300 for a business worth $100 just because everyone is talking about it.

That risk feels especially real right now, with some market watchers warning that the current boom in artificial intelligence stocks may be a bubble that could soon burst.

The Main Types of Fundamental Analysis

Quantitative Analysis

Quantitative analysis focuses on the numbers, such as revenue (a company's total sales), profit, debt, cash, and the ratios built from them.

It shows how the business is performing today and how that performance has changed over time.

Qualitative Analysis

Qualitative analysis looks beyond what numbers can’t tell you. That includes brand strength, management quality, and the level of competition.

A fading brand, executive turnover, or a new rival that’s shaking up the industry eventually shows up in financial results.

Top-Down vs. Bottom-Up Analysis

Top-down analysis starts with the big picture, such as interest rates or consumer spending. It then focuses on the specific company.Bottom-up analysis examines the strengths and weaknesses of the company first and then puts it up against the big picture. 

It’s important to remember that fundamental analysis reflects past performance. It can give you a good sense of how a company has managed its business, but it can’t tell you what will come.

Also, by the time you’ve done your fundamental analysis, the stock price may have already factored in all the changes that have occurred.

Using Quantitative Analysis

Interpreting Financial Fundamentals

Publicly traded companies file a detailed annual report called a 10-K and quarterly reports called 10-Qs with the Securities and Exchange Commission. Anyone can read them for free on the SEC's EDGAR database. In these fillings, you’ll find:

• The income statement that shows whether the company made a profit over a period of time, such as a quarter or a year.
• The balance sheet, which is a snapshot of what the company owns and owes at a specific point in time.
• The cash flow statement that tracks how cash came in and went out.

From these statements, you can first look at the fundamentals that show you how well a company is making money. They include: 

• Revenue: Also called sales, it’s the total money customers paid the company.
• Net income: It’s the company’s profit after subtracting all expenses. If expenses exceed revenue, it’s a net loss.
• Earnings per share: This is the portion of a company's profit allocated to each of its shares. EPS is an indication of the company’s profitability.
• Profit margin: It’s the percentage of sales that the company keeps after it’s subtracted all its costs.
• Free cash flow: After paying all its expenses, this is how much cash on hand the company has left.
• Debt-to-equity ratio: It shows how much a company relies on debt vs. using its own resources.

Interpreting Valuation Fundamentals

These numbers compare how well a company is making money to its stock price. They include:

Price-to-earnings ratio: Also known as P/E, it divides the share price by earnings per share. The lower the P/E ratio, the higher the earnings compared to the stock price, and the more attractive the stock may be.

Price-to-sales ratio: It compares a company's stock price to its revenue, showing how much investors will pay for each dollar of sales.

Price-to-book ratio: Book value is what is left after subtracting a company's debts from its assets.The price-to-book ratio compares the share price to that figure. It’s most useful for banks and asset-heavy businesses, and less useful for software companies whose value lies mostly in ideas and people.

Using Quantitative Analysis

The numbers behind quantitative analysis can tell you a lot, but there are other unmeasurable factors investors need to consider as well. Questions to answer include: 

• Business offerings: Is the company addressing the needs of the target market? Are its products, services and brand identity in tune with current market demands, and is it innovating for the future?
• Industry Placement: Does the company have a competitive edge that can drive further success? Does it have a patented process or product that protects it from competition?
• Company Leadership: Do the top executives have relevant experience to drive business growth? Do they have a proven track record of success in similar environments?
• Future Growth: Is the company's industry recession-proof? Is it a new or growing industry? Does the industry have strong long-term demand and growth?

You’ll have to look beyond a company’s 10-Ks and 10-Qs for qualitative information. Financial news outlets, such as Benzinga, are great sources. You can also read reports from analysts at brokerages and industry research firms.

How Is Fundamental Different From Technical Analysis?

Technical analysis studies historical price movement  and trading volume to predict where a stock will move next. It doesn’t ask what the company does or earns, and it it has a shorter-term focus

Fundamental analysis asks what the business is worth, which makes it better suited to long-term investing.

Some investors combine the two techniques, using fundamentals to decide what to buy and chart patterns to decide when.