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Stock Analysis 101: Fundamental Analysis

NEW YORK (TheStreet) -- When it comes time to make investment decisions, it's a good idea to be guided by more than just your gut instincts. If used effectively, fundamental analysis is one of the most useful ways to determine whether a company is a good investment choice. Even if you don't have a finance background, don't let that stop you from becoming your own personal stock portfolio analyst.

Fundamental vs. Technical

When it comes to stock analysis, there are two main schools: Fundamental analysis and technical analysis. Fundamental analysis is all about using concrete information about a company's business to try to find the real value of a stock, while technical analysis eschews all of that in favor of looking at the way pure market factors will affect a stock's movement.

They call it fundamental analysis for a reason: It can be fundamental to your ability to make money in the stock market. When you take a look at a company's fundamentals, you're judging its corporate health. After all, who wants to invest in an unhealthy company? This is a mantra that the likes of über-investor Warren Buffett uses, so why shouldn't you?

Business Basics

Before you begin to analyze public companies for their investment potential, you'll need to understand some business basics, particularly those relating to the company's financial statements. Financial statements are to an analyst what a patient's bloodwork might be to a doctor; they're the main data points that can be used to assess overall health. There are three principal financial statements: The income statement, balance sheet, and statement of cash flows.

The income statement subtracts expenses from revenue to get the company's income or profit. The balance sheet compares a company's assets against its liabilities and stockholders' equity (they balance each other, hence the name of the statement). Lastly, the statement of cash flows breaks down money taken in and doled out by its purpose (for example, operating, financing, or investing activities).

Financial statements are integral to fundamental analysis since they provide you with the numbers you'll make use of in your analysis.

But numbers aren't everything in fundamental analysis. In addition to quantitative performance measures (like the numbers you'll find in the statements), companies provide investors with a wealth of qualitative information as well. In every public company's annual report, management has an opportunity to explain their performance (or lack thereof) over the past year as well as plans for the future.

This management communication shouldn't be taken lightly. It could provide you with an understanding of why numbers were the way they were and what to expect in the future ("Talking to Management, Part 1: The Big Questions, Part 2: Gleaning Financial Subtleties").

What Is Performance?

When you hear about a company's fundamental performance, its stock price doesn't really enter into the equation. In the context of fundamental analysis, performance refers to the efficiency with which a company moves toward its goals. The degree of that performance is what we use to categorize a company as healthy (investment potential) or unhealthy (investment poison).

Depending on what metric you're looking at, performance can be measured in a number of different ways. If you want to look at a company as a whole, then its ability to generate a profit is a sensible measure to review (see earnings). However, if you want to be more specific in your assessment, you can be. For example, if you want to check the performance of certain assets, then you would want to look at a metric like return on assets (ROA).

There are several numbers and ratios that can be used to gauge a company's performance. Metrics like the price-to-earnings ratio ("Booyah Breakdown: The Ratio King"), earnings per share and gross margin are all useful in determining a company's relative health.

Compare Comparable Companies

When comparing the performance of two companies, it is important to remember that comparisons aren't absolute. For example, looking at a technology company like Google, whose P/E on any given day is almost four times as high as that of U.S. Steel, won't tell you as much as you'd think. While a lower P/E is generally more favorable (suggesting that a company with a given stock price takes in greater profits), U.S. Steel is in the basic materials sector, which as a group doesn't trade with a P/E comparable to the tech sector.

So how should you, the burgeoning analyst, approach metrics? Like this: Use ratios and comparisons only among comparable companies in comparable industries or sectors ("Industries vs. Sectors: What's the Difference?"). For example, while eBay's fundamentals might make it look like a pig (a bloated and overvalued stock) compared to The Bank of New York's fundamentals, the two aren't in comparable fields, so the intrinsic value of each stock is no clearer for your comparative effort.

(More suitable comparisons for eBay would be Amazon.com or Yahoo!, while JPMorgan Chase or Bank of America would work for the Bank of New York.)

Analyze Like a Pro

One of the big ideas behind fundamental analysis is that you're buying the stock to get the financial benefits of owning a prosperous company (see equity), not for the quick and dirty capital gains sought by daytraders.

Fundamental analysts strive to find companies whose intrinsic value is greater than or will be greater than its market value (this market approach is commonly referred to as "value stock" investing).

What's the key to using fundamental analysis like a professional? Benchmarking. Benchmarking is essentially the process of observing standards against which you can measure the stock you're analyzing. Unfortunately, there are no hard and fast rules for fundamental analysis, which is why even the professionals get things wrong every once in a while.

The best way to strengthen your fundamental analysis skills is through practice. How? Benchmark stocks, develop opinions about them, and analyze the results. Benchmarking, specifically, takes work (no doubt) but it's also the only way to get a feel for the way "good" fundamentals should look.

Homework Time:

Here are a few valuable activities you can do to hone your fundamentals skills:

1. Track two stocks for three months. Pick one stock you like instinctively and one you don't. Take a look at the fundamentals of each, and try to make an objective decision about each stock based on those fundamentals alone. Keep a record of how each pick progresses from selection to the three-month mark.

2. Create a fundamental checklist. Take the ratios, numbers, and other information you use the most, and write them all down on a sheet of paper. Make copies, and use this checklist (or "cheat sheet") whenever you analyze a stock. This will help you keep a handle on all the data you'll be reviewing on a regular basis.

3. Build your benchmarks. Every time you analyze a stock you're interested in (using your handy new cheat sheet), take a look at no less than one other player in the same industry to use as a benchmark. As you build a larger mental library of benchmarks, you'll likely find even greater success with fundamentals.

At the time of publication, Elmerraji had no positions in any of the stocks mentioned in this column, although positions may change at any time. Jonas Elmerraji is the founder and publisher of Growfolio.com, an online business magazine for young investors.

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