Welcome back for series 2 on the basics of investing in the stock market. If you are new to my blog, welcome. This is a 5 part series of how to invest in the stock market. Be sure to check out series 1 of this topic at the end of this post, simply click on the link in the end.
Today, I will be focusing on a question I get asked often: how does one know what stocks to buy or which companies to invest in? Should one feel patriotic to buy a company’s stock because it is in one’s hometown? or because one’s best friend has just invested in that company’s stock?
Fundamental analysis is the answer. This is very important for medium to long term investment horizon decisions.
What is Fundamental Analysis?
Fundamental analysis is all about getting an understanding of a company, the health of its business and its future prospects. It includes reading and analyzing annual reports and financial statements to get an understanding of the company’s comparative advantages, competitors and its market environment. There are 3 essentials of fundamental analysis:
Balance sheet fundamentals: A company’s balance sheet reflects its assets, liabilities, retained equities, and more. Before you invest, be sure you understand these critical terms and what they reveal about the financial health of your potential investment.
Income statement fundamentals: how do you know if your company is doing well? Learn how to read an income statement and how gross income and gross margin are calculated
Cash flow fundamentals: Depending on the credit market, your company’s operating cash flow is critical to surviving challenges. You’ll need a deep understanding of what a cash flow statement reveals — and what it doesn’t — as you identify potential opportunities for growth.
I should stress that once you have the results of your fundamental analysis, you want to then compare Company A to other similar companies in the same sector / industry. Because the fundamentals change based on industry, it won’t make sense to compare Apple, for example, to McDonalds. Two different companies with 2 different drivers and market dynamics.
Investing in the stock market is just like any other venture worth taking but you have to do your homework, research and continually educate yourself on it. Just as you continually improve your job skills, it is the same concept here. Practice makes perfect. Subscribe to blogs like mine for information. Read financial newspapers such as the WSJ, Bloomberg and visit news sites such as Google Finance to stay abreast of industry news, sectors, companies and overall pulse on the economy.
In my next 3 blog posts, I will do a tutorial on each of the 3 essentials of fundamental analysis showing how it really works.