In this 12-part Cadence Investing Series, we discuss several aspects of the investment process and how it actually works in practice. Topics covered include market psychology and fundamental analysis, and aim to provide the reader with a first-hand view of how financial theory stacks up in real world situations.

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After having written three articles on the behaviour and psychology of the market and stock investing, let’s turn to some of the traditional tools used by investors in assessing equity investments.

I should pre-warn readers that if you found the big influence that psychology plays in the investment process unsettling, the news around fundamental analysis is equally unsettling.

The word “fundamental” is defined as “forming a necessary base or core; of central importance” or “a central or primary rule on which something is based”. The word sounds very serious and important and almost hints at something that is not in dispute.

When someone says, “I am a fundamental analyst,” it sounds impressive and serious, and not open to much debate.

Here are the facts though. A fundamental analyst spends his or her days trying to estimate the future earnings of particular company’s shares. Put another way – days are spent trying to guess the future earnings of a share.

Put in an even bleaker light – days are spent trying to guess what the future holds for a particular industry or particular company.

In Jack Schwager’s Market Wizards: Interviews with Top Traders, successful investors refer to fundamental analysis as “funny mentals” or “guess-damentals”.

There is only one thing we know with certainty about a fundamental analyst’s target price for a stock – it will be wrong.

These investors realise that trying to predict the future even one year forward is very difficult and fraught with danger. Actually, buy and sell-side analysts try to predict company earnings two and three years into the future.

I have even heard of analysts who do 10 and 20-year discounted cash flows to try and assess the value of a particular stock today. A general rule of thumb on predicting the future is, that the further forward you try to predict, the less likely your predictions are to be right.

What then is to be done when the very basis on which we evaluate stocks is exploded for the myth that it is?

Well, before we all give up completely let’s give fundamental analysis its dues and position it where it belongs. Fundamental analysis is one of the very few tools we have at our disposal to evaluate an equity and should be used as such.

Fundamental analysis is not gospel or a statement of fact or a tool with any high degree of accuracy. Fundamental analysis is a tool that, if correctly used, allows us to get closer to what the value of a stock might be in the future.

There is only one thing we know with certainty about a fundamental analyst’s target price for a stock – it will be wrong. That is, it will either be too high or too low!

What fundamental analysis is really good for is running scenarios to determine the possible ranges of value a share could trade in, and as such, is a useful tool.

What fundamental analysis is really good for is running scenarios to determine the possible ranges of value a share could trade in, and as such, is a useful tool.

For example, with a Platts 62% iron-ore price of $50 per tonne, Fortescue Metals (FMG) would make no money and be of little economic value. With an iron-ore price of $80 per tonne, Fortescue would earn huge cash flows and could pay off all of its debt in less than three years.

The conclusion is that the value of a Fortescue share is highly dependent on the price of iron ore and predicting the price of iron ore is notoriously difficult.

Therefore, anyone that claims to know the fundamental value of Fortescue two years from now must have unique insight into the iron-ore price two years from now.

Recognising the severe limitations of fundamental analysis is important before we describe the different forms of fundamental analysis commonly used. As a tool, fundamental analysis provides useful insights into a stock’s possible range of valuations.

In our next article, we will focus on the quick-and-dirty price-to-earnings multiple that tells us little about the value of a stock but is widely used by the investment industry.

If you enjoyed part four of the Cadence Investing Series keep an eye out for our weekly articles, eBooks and 56 Books To Read Before Buying Your First Stock.