Stock Fundamental Analysis the Easy Way

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Fundamental analysis is a powerful tool for stock investors. However, it is also easy to try to tackle too much analysis and wind up paralyzed. It is also true that many financial educators and analysts over-complicate fundamental analysis to create a mystique around their proprietary methods to create a “need” for their service. However, I will show you that (With proper diversification) the process of fundamental analysis can be safely streamlined considerably.

Fundamental Analysis – Part 1

In the video I reduced fundamental analysis to a single benchmark ratio*. This ratio is called Return on Equity (ROE) and is used by financial professionals to compare stocks that are closely related so they can pick those that should be added to a growth portfolio.

Return on equity tells you how the company is performing based on its ratio of profits (yes, those are always a good idea) to owners equity (the “owner” is you the shareholder). This ratio basically connects the income statement to the balance sheet.

ROE, summarizes all of a company’s critical activities and financial measures into a single ratio, which makes it easy to calculate, search for, and understand. However, like all fundamental data, context is necessary to define a “good” or “bad” ratio.

Fundamental Analysis the Easy Way – Part 2

In order to really understand why fundamental analysis does not have to be complicated you need to understand some of the common mistakes traders make when using fundamentals to find stocks to trade. These issues include the following:

1. Traders try to invest in those companies with the most extreme fundamental scores. The issue with this approach is that it constrains choice and finds stocks at extremes that are likely to be volatile. As a trader, you want a lot of choice and controlling volatility is paramount.

2. Indicator piling or adding more and more criteria, scores, and ratings is common because an inexperienced investor assumes that it will increase the likelihood for a good trade. This kind of probability analysis does not improve forecasting because the variables are independent (without replacement) and cannot affect each other.

Additionally, traditional probability analysis breaks down in the market because stock prices are not normally distributed. Adding more analysis increases your work load and will deliver less choice and smaller returns.

3. Context or the overall market and industry environment that a stock exists within must be considered when adding a stock to a diversified portfolio. Trying to compare fundamentals across industry groups and sectors loses meaning because businesses are managed so differently.

4. One of the reasons the financial markets work so well is because there is a very high degree of transparency. That means that most financial information that could be known about a stock is broadly known by investors. Therefore, most fundamental information has already been included in the stock’s price. Don’t fall for sales pitches that show you today’s fundamental score and indicate that this predicts future success.

The good news is while fundamental analysis is not likely to show you any “hidden” information it can help improve returns by lowering volatility.

Fundamental analysis will not perfectly predict the future of any stock, which is true of all types of financial analysis, however, it will remove some of the “unknowns”. For example, some of the most dangerous unknowns are those that surround a stock or company that has yet to provide profits or has not done so in a long time.

A stock like this is driven exclusively by trader expectations about the future since the company has not proven that it can perform in the past. Trader expectations are extremely volatile and can lead to large amounts of concentrated risk.

Fundamental Analysis – Part 3

Fundamental analysis can also help identify companies that are operating at extremes. Too often those with unusually high or low ROE numbers will also be very sensitive to the market and can be excessively volatile. As a general rule, I have found that it is acceptable to look for stocks with an ROE measure 10-40% greater than the average of their industry group or sector.

Doing this simple analysis removes many of the unknowns and creates a large selection of companies to choose from when building a diversified portfolio of stocks.

Fundamental analysis may not need to be complex but searching for stocks that look best can be difficult without a way to automate the process. One of the great opportunities of online investing is the breadth of stock searches available for free. They are very robust, easy to use and often integrated with your online broker.

The video below includes a demonstration of just one of these tools. The stock screener I will be using is very representative of tools available for free around the internet. Practice on your own using one of these tools and add stocks to a paper portfolio. It may surprise you to see what you can find on your own.

Fundamental Analysis – Part 4

*Author’s Note: I am fully aware that there are fundamental junkies out there in “Market-land” writhing in pain and mental anguish at the thought that I would preach such heresy. Therefore, I would encourage you to share your thoughts in the discussion forum. But remember, the goal here is to provide education that can reasonably be used effectively by new retail investors. For those of you with questions about this approach to fundamental analysis, please ask your questions there as well.