Fundamental Analysis For Beginners – Stock Market 101 For Dummies
I’ve decided to talk more about this topic in detail and go deeper into the world of investing and trading because I’ve been in a position where I have zero idea on how the stock market works and wish that someone could actually lead the way or break things down to a dummy like me. ?
Like, stock market 101 for beginners or dummies.
So in this post, I’ll talk about all things you need to know – how the market moves, how research is done, how many hours should you spend, and basically how the richest investor makes money out of the stock market.
This post will be in one of my stock market series so there will be more stock market articles coming soon! If you do have questions or things you would like to know more of when it comes to the stock market, please leave a comment down below ?
So ready your pen and papers, write down all the important points and let’s get right to it. ??
Fundamental Analysis For Beginners – Stock Market 101 For Dummies
Generally, there are two types of analyses that are done by traders and investors when they buy a stock – those would be Fundamental Analysis and Technical Analysis.
Fundamental Analysis – This is the study of a company’s intrinsic value. Investors who use this style of analysis look for different factors within the company that can influence price in the future. The most basic factor they look at would be the earnings of a company.
-Basically you’ll be doing research on the company’s background & economy before investing.
Technical Analysis – This method is used when investors study the company’s stock chart. When using this type of analysis, they are looking for patterns in the chart to see where they could possibly buy a stock that will give them a low risk but high reward.
-You’ll be looking at the chart’s movement when buying stocks.
Which Analysis To Use?
In the vast world of the stock market, you’ll read about different investors and traders that became successful by using technical and fundamental analysis. Some people combine those two to get the best of both worlds.
It’s definitely up to you on which one you’d prefer to learn. But before you decide on which analysis to do, I’d recommend studying both so you’re not missing out on anything.
As mentioned in the title of the blog, this post will be mainly focusing on fundamental analysis first. We’ll discuss the main goal when it comes to doing fundamental analysis and the different factors that investors look at when they use this method.
Fundamental Analysis Beginners Guide
Fundamentalists use a common framework to know whether a company has the potential to grow and that framework is called the top-down approach.
Using a top-down approach, fundamentalists look at the economy first. They look for a strong and progressive economy that is beneficial when doing business.
Next would be looking at the flourishing industries within that economy.
And lastly, they focus on companies that are growing within that industry.
Their thinking goes like this: They search for a strong economy, but in order for an economy to be progressive, there’s a certain industry that’s leading the pack and for an industry to push an economy, there’s a company that’s cut above the rest, a company that’s so strong that it moves the whole industry with it.
When starting the top-down approach, investors usually look at different economic indicators like;
- Inflation Rate
- Interest Rates
GDP basically shows how productive a country is.
If you want a more textbook approach, well, by definition, a GDP or growth domestic product is the total worth of goods and services produced in a country.
When the GDP is increasing, it means that the country’s economy is progressing or expanding.
For example, let’s look at the GDP of China and the US over the years:
As you can see, both China and the US have gradually increasing GDP. That’s why they are the top two economies in the world.
If the GDP of a country increases yearly, this means that businesses are healthy and earning more.
Another factor that investors look at under the economy section would be the inflation rate.
Inflation happens when prices rise due to overwhelming demand from consumers. With more demand, the prices of goods and services become more expensive.
Although more demand is good, a high inflation rate would mean a higher cost of living. The production of businesses and services will become higher as well.
It’s like a vicious cycle.
So in order to make sure that inflation is not going through the roof, the central bank of a country always keeps the inflation rate to a certain percentage. According to Economics Help, a healthy inflation rate would be at 2%.
Let’s look at the inflation rate of the US over the last decade:
So why do investors look at the inflation rate?
They do so because when inflation is rising, this means that goods and services also increase which makes a good portion of the population lessen their spending and in return may affect the earnings of some companies listed in the market.
Again, fundamentalists closely monitor a company’s earnings before they invest in it.
They do so because obviously, we want to invest in a company that’s sustainable and earns money to keep their business growing.
The last indicator that we’ll talk about under the economy section would be interest rates.
Interest is the cost of borrowing money and the interest rate refers to how “quickly” the borrowing cost will increase.
For example, you go to the bank and apply for a $100,000 mortgage, and the bank prints out an agreement that you will pay that loan with a 20% interest. This means that you’ll pay a total of $120,000 by the end of your loan.
Interest rates affect the stock market in the context of consumer spending.
Basically, if we’re on a period of high-interest rates, it will be less attractive for people to loan from the bank because they’ll have to pay higher interest. (like duhh?)
If fewer people can loan, there would also be fewer people spending money.
The same goes for companies! A high-interest rate is a turn off to business owners because it will be much more expensive for them to loan money.
For example, if a person loans from the bank and interest rates are at 10-12%, to a small debt it’s not much. But if you compare it to big companies who borrow hundreds of millions from banks, that 2% difference would cost them a lot.
Let’s say Company X needs funding for their project and they need to loan $100 Million from the bank.
If the interest rate is at 10% for 5 years, the interest payment alone is at $50 Million.
On the other hand, if the interest rate is at 12% for 5 years, the interest payment is at $60 Million.
That $10 Million difference could be a make or break factor in whether Company X will continue their project.
As you can see, a high-interest rate affects everyone.
People can’t loan from the bank and companies might wait for a couple of years to start their projects.
If people can’t borrow from the banks ⏩ fewer people will use services and consume goods from companies⏩ which then affect the companies earnings.
If companies can’t loan to fund their projects for their expansion ⏩ that will affect their potential earnings as well.
Do you now see the chain reaction of a high-interest rate? ?
Rule of thumb is basically the higher the interest rate, the less attractive it is to invest.
All of these indicators – GDP, Inflation Rate, Interest Rate, are studied because they can impact the economy of a country.
The healthier the economy, the stronger the businesses. A strong business has great earnings. Earnings are one of the important factors that fundamentalists look at when finding a company to invest in.
But looking at the economy is just one thing to study, to go deeper we would be looking at the strong industries within it. ?
Now that you know what indicators to look at when searching for an excellent economy, it’s time to find the industry leaders.
Take note: The terms industry and sectors are used interchangeably because both terms describe a group of companies that operate in the same segment or business field.
According to The Balance, there are 11 sectors found in the S&P 500 namely:
- Communication Services
- Consumer Discretionary
- Consumer Staples
- Health Care
- Real Estate
Companies in the stock market are clustered into different sectors. This makes the process of researching easier.
Some Real Life Examples
For example with the 2008 housing bubble, among the sectors listed above, what sector would have been hit greatly because of the housing market crash? It’s real estate. (Although all sectors were falling during the recession).
If you had the foresight in seeing that the United States economy was under a housing bubble, you would have sold all your stocks that were under the Real Estate Sector or just simply all your stocks.
Consider this ongoing pandemic that’s been happening, if you’ve read the news the past months, employees were forced to work from home and others were “locked” inside their house.
If people were working from home and the majority of the consumers were forced to stay in their house, what sectors would have benefited this situation? ?
In my opinion, consumer staples wouldn’t be a strong sector since most restaurant stocks might bring them down. Restaurant stocks might take a hit for the reason that they are closed for months because of the government mandate.
Since people are stuck at home and work is conducted there as well, I think that Technology, Communication Services, and Consumer Directionary might be the resilient sectors in this pandemic.
I believe that the technology sector can benefit from this situation because people will still be using technology stocks like Apple and Microsoft regardless of where they are.
Plus, since work from home is mandated, I’m sure that there’s a ton of employees that would be downloading Zoom for corporate meetings. (Who else is feeling FOMO for not putting money into Zoom?! ?)
And to add to that, what do people do nowadays when they get bored in their house? They watch Netflix! So people who didn’t have the time or were not subscribed to Netflix’s services before will now open an account with them.
That is how fundamentalists think as well. Even though the economy is hinting of a temporary decline, they will research for a sector that will remain strong or that will less likely be hit by the effects of the pandemic.
Once they found their chosen sector, they go to the last section of the top-down approach which is the company that will lead within the sector.
There are several ways on how to analyze companies. The two major approaches would be:
Quantitative Research – Understanding the numbers behind the company. (reading financial statements)
Qualitative Research – Understanding the story behind the numbers – studying the company inside.
When fundamentalists look at the income statement, balance sheet, and cash flow statement of a company, they are using a quantitative approach.
Here’s an example of Amazon’s annual income statement taken from Investing.com:
It might be overwhelming at first glance, but if we define the important terms and sections to look at, it will make the process easier! ?
Revenue – This shows how much the company made from its main operations.
Cost of Sales – The cost of the items sold or services provided by the company. This includes the labor, raw materials, and manufacturing of products and goods.
Gross Profit – This the difference between net sales and cost of sales. This is the profit that the company makes after deducting the costs relating to making and providing services.
Selling, General, and Administrative Expense – Also known as SGA. The value here refers to the company’s operational expenses. SGA includes all the costs not relating to making and providing services.
Operating Income – This number represents the company’s earnings from its normal operations before taking into account taxes and interests.
Interest Expense – This shows the costs of the company’s loans.
Net Income – This is the “bottom line” which usually tells whether the company was profitable that year or quarter or not.
For an in-depth explanation of understanding these terms, you can watch the video below!
For us beginners, knowing the basics of an income statement is already enough.
With the defined terms mentioned above, we could already have an idea about Amazon’s operations throughout the years.
If you look at the lower portion of a balance sheet, you’ll find words like EPS, P/E, and P/B. These are what you call financial ratios. (I know it’s a bit tedious, but it’s all gonna be worth it!)
Financial ratios help investors analyze and compare relationships between different financial information.
EPS (Earnings Per Share) – This ratio is calculated by dividing the company’s net income with its total number of shares. EPS indicates the profitability of a company which means the higher the EPS of a company, the better its profitability.
P/E (Price to Earnings) – This measures how much you’re willing to pay for every single amount of dollar is able to earn. You calculate this ratio by getting the stock’s price and dividing it by the EPS.
P/B (Price to Book) – This ratio is used to compare a company’s current market price to its book value. This value is derived by dividing the stock price by the book value of a share in the latest quarter.
If you’ve just encountered these terms, I know it can be a real headache. It was for me too.
But sometimes, these ratios are already calculated in an income statement of a company.
When using financial ratios, it’s best that you compare it to other company’s EPS, P/E, and P/B. This is known as “benchmarking”. By benchmarking, you’ll know when a company is expensive or cheap compared to its peers. Then you go deeper as to why it’s cheap compared to other companies in the sector. 🙂
When doing qualitative research, investors study the business model of a company – how they’re conducting their business, what’s their edge, and how is the company managed.
In qualitative research, there are four keys that are looked at frequently:
1. Business model
An investor looks at the business model of a company to determine how it creates and delivers services and goods. It is typically at this point that investors look at how the company makes money.
Investors look at the people who are leading the company. Do they have a track record of building businesses? Were they related to scandals before?
Even if the company has the best business model, if they are led by people who aren’t fit for the job, the company is set to fail.
3. Competitive Advantage
Having a competitive advantage makes a company stand out from the rest. This is what drives a company’s longevity in the game.
If investors find that such an advantage is sustainable for a long time, the company will be much more appealing to them.
4. Corporate Governance
This represents the rules, practices, and processes used inside the company.
Corporate governance can also determine how strong the relationship is between management, directors, and stakeholders.
As you can see, when using qualitative research you study the internal part of the company. You determine the reasons behind the numbers in the financial statements. You also look at how people carry the company, how they do business, and what sets them apart from their competitors.
Reading The News
Another way of looking for a company that’s leading within a sector would be simply reading the news.
A bunch of news outlets has reported that the US unemployment rate has been on an all-time high. This means that employees have been laid off left and right.
This pandemic has left millions of Americans jobless.
But there was one giant company, an industry leader, that amidst the pandemic and rumors of an economic crash, they kept hiring people and attended to their customers. This company was Amazon.
According to The Verge, AMAZON DOUBLED ITS PROFIT DURING A PANDEMIC.
It was on July 30, 2020, that Amazon released its earnings report for the second quarter of the year. It was on that report where they wrote how they spent the company’s money, where they got their sales, the different projects they started, etc.
But before the earnings report was released, in a CNBC article posted on May 28th, 2020, they hinted that Amazon’s move of hiring more employees signifies an increase in sales.
And that CNBC article was free for the public to read.
I stress that it was free information because if you were not sure if Amazon can survive this pandemic, that news article already gave the answer.
Investors who placed more money in Amazon because they saw that the company kept their business running and had good leadership, were rewarded monetarily.
Amazon’s stock price is at an all-time high as of this writing. Meaning, the stock price of Amazon is at its highest that it’s ever been. ???
So that, folks, is how you use the top-down approach when looking for a company to invest in.
First, you start looking at the economy, you’ll use the economic indicators to determine if the economy is strong or stagnant.
Once you’ve determined whether the economy right now is a good time to invest, go and find industries or sectors that are leaders. Another way to look at this would be what industry will benefit the current economic situation?
After you’ve figured out what industries are leaders or soon to be leaders, go deeper into that sector, and look for companies that are healthy and resilient. Answer what companies can benefit from the current economic state and most importantly, which companies are earning.
How Do Fundamentalists Make Money?
People who use fundamentals make money in the market when they see mispricing.
Mispricing happens when an investor sees that a company should be valued at $50 per share and its current price is only $35.
It was the investor’s research, study, and financial model that made them come up with that value.
The value that they got would be called intrinsic value. But professionals in the financial world don’t rely on their perceived value alone. They compare it to other professionals in the field and get the average of all the perceived value of a certain company.
Having this logic means that doing fundamental analysis allows you to determine the future price of a company.
Investors who use and believe this approach is constantly finding mispricing in the stock market to make money.
Does fundamental analysis work?
Warren Buffet, one of the richest men in the world uses this approach when it comes to investing. He studies companies and the numbers behind it.
Since one of the richest men uses this approach, that’s enough reason for me to believe that fundamental analysis works!
But when it comes to trading, traders don’t use this approach because they have a shorter time frame when buying and selling stocks.
Watch out for the next part of this Stock Market 101 for beginners series wherein we’ll go into the world of understanding charts and patterns. And how these patterns can determine the next movement of price!