At its core, fundamental analysis is the preferred method of picking stocks for a large group of investors, which are often called value investors. The big idea is that the purpose of owning stocks is to receive a sliver of a company’s profits. For this reason, the key to valuing stocks is to predict the earnings that flow down to the bottom line of the company’s balance sheet over time. Companies that make large profits are worth more than companies that don’t’ make as much profit. Companies with growing profits are worth more than companies that are not growing very fast.
If prices were set based on past performance, then there would be very little disagreement about what stocks were worth, and the prices would be more stable over time (similar to bond prices). The price of stocks (according to the fundamentalists) reflect the consensus estimate of a company’s discounted future earnings. The fact that forecasting is involved is where animal spirits sneak in to even the most carefully laid equations, injecting what mathematically ends up being a near random component in stock prices.
I believe that the true value of stocks is composed of profits that trickle down to the company’s bottom line and into shareholder’s pockets. If we fit a regression line to a basket of stock prices that spans decades, we can get a good idea of what that true value is today, and we can get a good idea of where that value is going to be in the future. The problem is that stocks rarely ever trade at their true value; they trade at their market value.
It is worthy of note that Mr. Warren Buffett is often called a “value investor,” and that is the foundation of his intellectual heritage.
References and Further Reading
If you want an in-depth understanding of Warren Buffett style security analysis, I strongly recommend his most recommended text, Security Analysis by Benjamin Graham and David Dodd.