Fundamental analysis is one of the most important ways investors have to evaluate a stock both in qualitative and quantitative terms. Although technical analysis can be useful in some situations, it falls short when it comes to making long-term investment decisions. But why is fundamental analysis so important? Let’s take a look at the top reasons why fundamental analysis is important and it is imperative that investors use it when they are researching and investing in stocks.
1. Understand the business model
Fundamental analysis is what allows investors to understand the business model of any company, from a quantitative and qualitative standpoint. Without fundamental analysis, it is not possible to understand whether a business model is sustainable and successful.
By understanding the business model you will also be able to compare it with competitors and understand the value proposition of each business.
2. Analyze the competitive landscape
In order to invest in a company, it is important to understand the competition it faces, and to analyze the competitive landscape of a business you need to use fundamental analysis. This is the only way to effectively conclude whether the company is able to compete and gain market share, or not.
3. Does the company have a moat?
Identifying a moat or competitive advantage is the key to investing in companies for the long term. You want to make sure that the stock you are investing in is a company with a long-standing moat, that is able to compete and remain a dominant player in its industry.
Fundamental analysis allows investors to understand how the company is able to compete over the long term and to predict whether or not the company might remain relevant 10 or 20 years from now.
4. Valuing the business
One of the main reasons why fundamental analysis is important is that it allows investors to value a business. Looking at a stock chart can help you predict the movement over the next few days or weeks, but it can’t tell you how much the whole business is worth. The only way to determine whether a stock is worth investing in is whether or not its stock price is lower than its valuation.
Business valuation is a highly subjective topic that requires research, and experience. While it is one of the reasons why value investing is difficult, it is also one of the best ways for investors to get rewarded in the market. By finding stocks trading under their fair valuation, you will be able to invest in them knowing that your shares are worth more than the market price.
5. Estimate future earnings
Fundamental analysis also allows investors to estimate the business's future earnings, and make projections as to how much the earnings will be in the future. Without analyzing the company’s financials, you will not be able to estimate revenues and earnings accurately.
6. Analyze management
How is the management running the business? Are they doing anything to create shareholder value? This is why using fundamental analysis is important to determine how the management is actually running the business. As an investor you want to make sure that the management team is doing everything they can to create shareholder value, and that they have a good understanding of their industry.
Reading the company’s financials, as well as the earnings calls will help you to determine whether the management is actually doing a good job or not.
7. Risk assessment
With every investment, there is always a risk, and fundamental analysis is important to understand each risk the company may face. Whether those risks are competitive, or perhaps the company has too much debt on its balance sheet or does not seem to be generating a high return on capital invested, it takes a fundamental analysis approach to identify every risk the company may face.
8. Corporate governance
Even if the company’s management is extremely capable, corporate governance will always influence shareholder returns. For this reason, investors need to understand who are the board members of the company and if they are going to protect shareholders. It is also important to check whether or not the board members have invested in the stock.
9. Understand the industry
Every industry is different, and it requires a different valuation and research approach. While most investors are often very familiar with certain industries, they also lack the knowledge and expertise in others. Fundamental analysis can help you understand how a certain industry works, and whether or not it is worth it to invest in certain industries.
10. Analyze the company’s financials
The company’s financials are the go-to place for long-term investors. You need to make sure that the company’s balance sheet is solid, and that it has plenty of current assets to meet its financial obligations in the short term. You also want to make sure the revenues are consistent and steady, and that it has a big enough margin to remain profitable if the current conditions deteriorate.
By analyzing the company’s financials can also help you in valuing the business, and analyzing whether or not the management is doing a good job at running the business. It will also help you to identify potential risks and project the future earnings of the company.
11. Understand whether a stock fits your investor profile
Choosing stocks that match your investor profile is extremely important, to make sure the volatility and risk, are in line with your financial goals. For that reason, fundamental analysis is important because it allows you to understand the potential risks a company faces, and adjust your portfolio based on that.
12. Estimate returns
While you can also use technical analysis to estimate the returns of a certain stock, they are not the best way of doing so. Past performance is not indicative of future returns, and you will have to understand how the company’s revenues and earnings are going to grow to potentially estimate the returns for each stock.
13. Investing for the long-term
Investing for the long-term needs to rely on solid fundamentals and research, and technical analysis is simply not enough to understand whether you should invest in a stock over the long term. Reading the company’s financials, and understanding its competitive position in the marketplace is the only way to determine whether you should invest in a company for the long term.
14. Comparing stocks
While it is possible to compare stocks based on charts, and price movements using technical analysis, that falls short when comparing two completely different stocks. Using fundamental analysis you will be able to tell exactly which stock faces more risk, which one is more profitable, and what the expected returns for each stock are. Using technical analysis can help you determine the best stock to trade in the short term, but it does not allow you to compare stocks in depth.
Why fundamental analysis is better than technical analysis
Technical analysis is certainly useful, and it can help you to determine how a certain stock is expected to trade, but it does not work if you are investing for the long term. Traders rely on technical analysis, but the investment cannot be based simply on patterns and charts alone. This remains one of the most significant differences between fundamental and technical analysis, and it is also the main reason why fundamental analysis remains so relevant today.