Many investors and traders when they hear the word fundamental analysis start sweating and get anxious, fundamental analysis need not worry you, if you know how to keep it simple. Follow the K.I.S.S principle when doing fundamental analysis. You don't need to do an MBA from Harvard or Stanford to master fundamental analysis. When you do fundamental analysis of a company and its stock, you should always start with these four basic questions! 1) What is this company's value relative to its peer companies? 2) What is this company's growth rate? 3) What is this company's return on capital? And 4) What is this company's debt level? When you have answered these four basic questions, you will get an idea what should be the true value of this stock. You don't need to fret over calculating the exact intrinsic value of a stock like a Wall Street Expert. You just need to figure out that this stock is worth between $20-30 while it is trading for just $15 per share at the moment. If you don't know intrinsic value, it is the supposed true value of the stock. It may not be what the market value at that time is. But over time, the stock will surely attain what it's intrinsic value is. Now why fundamental analysis works? How do you value a company. Suppose, you live in a rented apartment. You pay a rent of $1,000 per month. Your friend lives closeby and she lives in another rented apartment. She pays a monthly rent of $2000. You can understand that her apartment is two times more valuable as compared to your apartment. In the same way, you can value companies by their quaterly earnings. Each public company is supposed to issue its quaterly earnings reports to its shareholders. By looking at the quaterly earnings reports of different companies, you can rank them in importance of their value. The more quaterly earnings a company has, the more valuable its stock will be. Stock price has a relationship with the earnings of a company. Stock price is just the present value of the future earnings potential of the company as long as it is a going concern. Now, there is something known as arbitrage. You might have heard about it. Arbitrage opportunity arises when the investors and traders spot mispricing in the market. Suppose, there are two markets Europe and US. One ounce of gold is selling for $1100 in Europe and the same ounce of gold is selling for $1150 in US. This is a perfect riskless arbitrage opportunity. Arbitrageurs will immediately step in. Buying gold from the European gold market and selling it in the US gold market. This buying pressure in Europe will bid the gold price there to something between $1100 and $1150 per ounce. The selling pressure in US market will lower the price of gold to something like $1100 and $11500 per ounce. Eventually the gold price in both the markets will equalize. This is a perfect example of how arbitrage makes the markets efficient. Suppose a company ABC stock is selling for $10 and its' market value is $100 million with $150 million in cash and no debt. An arbitrageur will immediately detect this arbitrage opportunity and buy the company for $100 million. Use the cash to pay for its purchase. So, fundamental analysis works because firms, individuals and governments are always looking for making riskless profits in the market.
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