Trading stocks with fundamentals can be “fun” when you consider the payoff. The heart of fundamental investing is to find stocks that are priced below their actual value. The idea is that in time, money will naturally gravitate into stocks that offer the best bargains.
Fundamental analysis is something many traders tend to relegate to the back burner. This makes sense for those using a short-term timeframe; chart patterns and moving average violations are much more telling than the underlying business dynamics, which take time to impact a stock’s price.
Longer-term traders, however, can wield some basic fundamental analysis as a powerful tool for trade selection. The key to understanding this approach is taking the mystery out of the numbers. For those used to deciphering chart patterns, a list of dry figures or a balance sheet doesn’t lend much immediate information.
The bread and butter of the fundamental approach is to find stocks with attractive valuations. In a nutshell, a good valuation means that a company’s projected business outlook hasn’t yet been priced in by the market. The basic idea is that over time, money will naturally gravitate towards stocks that offer the best bargains. It’s a common-sense idea that can be easily overshadowed by other factors that attract traders’ attention: broader market dynamics, geo-political events, and so on.
The Price/Earnings ratio is one of the basic ways that valuation can be gauged. Generally speaking, a lower P/E suggests a more attractive valuation. Oftentimes you’ll see a company’s P/E compared against the benchmark S&P 500 average, which tends to hover in the 20-25 range.
A more useful approach is to compare a stock’s P/E to its primary competitors and the average for the overall industry. Utility stocks, for instance, often trade at relatively low valuations, while tech stocks clock in at higher levels. To use a real-life example, shares of Ameren (AEE), a diversified utility, have a P/E of 22. That’s roughly in-line with the broader market. But when compared to the overall utility sector, it doesn’t look quite so attractive; the average for the industry is 19.
Periodic business updates can provide another window into a company’s fundamental performance. For retailers, this includes the monthly same-store sales data. Analysts will venture guesses as to the results, just like they do with earnings.
When holding a retail stock, it’s always a good idea to be aware of any upcoming same-store sales announcements. These can often have a strong impact on the equity’s price, depending on how the actual results compare with the consensus estimate. Companies also frequently offer regular mid-quarter updates. All traders, regardless of their chosen timeframe should be aware of these events because of their potential impact on a stock’s price.