The Significance of Fundamental Analysis

Investing is done successfully by understanding direction, and velocity, not by looking at velocity alone. Velocity (in this simplified context) is the speed and distance a company achieves over time, this may be earnings, profit, sales or margin. Direction is which way the company is pointing, up or down, this speaks to a deep value assessment, or an understanding of the health of the overall business.

If you would like to profit from the stock market I would argue that you as an investor need to have a thorough understanding of each of these elements to truly estimate your risk in any given investment. Too often the analysis of companies is lopsided towards an appreciation of the sheer velocity with little regard to direction.

The Problem With a Velocity Only Focus

“An object [business] at rest tends to stay at rest and an object [business] in motion tends to stay in motion with the same speed and in the same direction unless acted upon by an unbalanced force.” Newton’s First Law

I see so much time spent in the general media trying to predict the future, trying the estimate the velocity a company will achieve over the next ten years. This will likely come as little surprise but analysts have absolutely no idea what will happen next year with the company let alone the next ten. This is what I mean by velocity. If a stock analyst spends 100% of their time trying to anticipate the speed at which a company will rise in the future without the aid of a crystal ball of some sort they are most certainly wasting your time.

Direction is More important than Velocity

I am not saying the activity of velocity analysis is without merit, velocity is the spice you add on the top of the meal, but not the main course itself. What you really need to understand is what the past can tell you about how the company is run and how healthy the company truly is. Consider this quote from Martin Fridson’s from Financial Statement Analysis: A Practitioner’s Guide:

“What financial analysts are actually seeking, but are unable to find in the financial statements, is equity as economists define it. In scholarly studies, the term equity generally refers not to accounting book value, but to the present value of future cash flows accruing to the firm’s owners.”

The chief purpose of fundamental analysis is then to achieve an understanding of the true equity of a company. What is that business really worth, how does it work, how does it make money. By becoming engrossed in these details a full understanding of the direction of a business can be determined.

Combine the Two

Determine the direction of a company first, spend the majority of your time here. Once you are sure you aren’t dealing with the poseidon then start looking at the velocity. Worst case if you are wrong about the velocity at least your ship will still be pointed in the right direction.