Fundamental analysis is one of the most important forms of analysis that you need to know before learning anything else about trading. That’s because it gives a complete insight into a company’s performance and the industry that it operates in.
By doing this, investors can assess whether a stock is undervalued or overvalued based on several factors. These include things like the price ratios of a company, its historical growth rates and dividend payments, as well as any prevailing trends in its particular industry.
Though there are many different ways to use fundamental analysis such as knowing how to perform ratio analysis for stocks, some of these methods have been specially designed for long term investments. In contrast, others are used more by short-term traders who want to make fast money.
How to use fundamental analysis in your investment strategies
So how do investors use fundamental analysis in their investment strategies?
Buy or sell
The most common method of using fundamental analysis is determining whether or not to buy, sell or short-sell a stock. When you buy a stock, for example, in London’s stock exchange (LSE), it means that you are purchasing an asset at its current market price.
This means that when you purchase the company’s stock, you believe that it will increase in value so much that your purchase becomes profitable in the future. This strategy works well if you bought that stock during a bear market or at the bottom of its trend.
For example, if you bought shares in Apple (AAPL) back in 2009 when the stock price was at US$ 65, you’d have enjoyed an astonishing +99.44% increase in your investment by January 2014. Not to say that all stocks will experience this kind of appreciation, but it shows what can happen when you buy at the “right time” (before an upswing).
Now imagine investing in Apple’s stock today- how much do you think AAPL stock will appreciate by tomorrow, next week or even next year? It would be hard to tell, considering that AAPL is currently trading above US$ 122 per share. If you were to use fundamental analysis today and if you estimated that AAPL’s intrinsic value was at US$ 130 and the market price is currently at US$ 122, you might consider buying more AAPL stock or short-selling it. Keep in mind that these are just estimates, but this shows how investors use fundamental techniques.
Short-selling is the opposite of buying a stock; when you sell shares of a company’s stock, you expect its value to decrease so much that your sale becomes profitable, when you buy a share, the total supply of stocks increases, while the total supply decreases when you sell a share (this is why prices go up).
Suppose we were to look again at Apple (AAPL) and estimate its future cash flows and intrinsic value. In that case, we might see that it is incredibly overvalued, and short-selling the stock would be a potentially profitable endeavour.
Disadvantages of using fundamental analysis
When used correctly, fundamental analysis can give a trader the unique insight to pick out attractive stocks and make huge profits. But its main drawback is that it takes time and experience before you start seeing the real benefits of the method. This is why many people prefer technical analysis (which analysts use to predict short term price movements) because it works faster than fundamental analysis.
Fundamental analysis can help you in many ways when trading stocks in the UK; not only does it provide knowledge to make educated financial decisions, but it also provides perspective on how other investors perceive a company’s stocks and their future prospects. We recommend you begin your investing adventure with Saxo Bank, a trusted online broker.