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How Fundamental Analysis Is Used to Analyze Stocks
Stocks are a great option for diversifying your investment portfolio. However, choosing the right ones isn’t always a simple process. Different investment tools and strategies, such as fundamental analysis, can help you decide which securities are worth your time and money. If you’re not sure what fundamental analysis is or how to use it to your advantage when investing in stocks, this guide may be able to help.
Fundamental Analysis: What Is It?
Fundamental analysis is a way to measure a stock’s value based on things that can affect that stock’s value.
The ultimate goal of fundamental analysis is to determine whether a stock’s current price reflects its true value. Knowing whether a stock is undervalued or overvalued can help you decide whether to buy or sell it.
How Does It Work?
Unlike technical analysis, which looks at stock market movements and patterns, fundamental analysis zeroes in on specific metrics or factors to estimate whether a stock’s value is realistic. Below are a few “fundamentals” or metrics that can be used to analyze a stock.
- Earnings per share (EPS):EPS represents a company’s earnings for each share of stock issued.
- Price-earnings (P/E) ratio: A stock’s P/E ratio compares the company’s share price to the earnings per share.
- Projected earnings growth (PEG): This number estimates a stock’s one-year earnings growth.
- Dividend yield: If a stock pays dividends to shareholders, the dividend yield reflects how much is paid out per share over a set time period, typically one year.
- Price-sales (P/S) ratio: This represents how a stock’s price compares to its company revenues.
- Return on equity:Return on equity is the result of dividing a company’s net income by its shareholders’ equity.
Essentially, this type of analysis looks inward, rather than outward, to evaluate the quality of an investment. All of these metrics are quantifiable. This means you can look at hard numbers and compare them before making an investment decision.
There are other fundamentals you may want to take into account, though you can’t necessarily assign a number to them. For instance, you might measure a company’s value in terms of its brand visibility, the quality or experience of its executive board, its approach to corporate governance and the company’s overall business model. However, it may be difficult to accurately estimate what these intangible metrics are worth.
While fundamental analysis works on stocks, it can also be applied to mutual funds, bonds or other securities.
What Fundamental Analysis Tells You About a Stock
Conducting fundamental analysis of a stock can give you an idea of how healthy it is financially. It can also tell you the level of earnings the stock is generating and how it’s valued in the eyes of the market. You can then use that as a starting point for deciding which way to move on a particular investment.
Stock experts use fundamental analysis to offer investors guidance on whether to buy or sell. For example, if analysis determines that a stock’s intrinsic value is higher than its current market price, the stock could be rated as a buy move since it’s undervalued. On the other hand, experts might encourage investors to sell if the opposite is true and the stock looks to be overvalued.
Fundamental analysis can be helpful if you’re trying to decide whether to buy and hold a particular stock or buy and sell to capitalize on an upswing in pricing. For example, if a stock you own has fundamentals that signal it is overvalued, you may decide to sell it. This could help you avoid any losses if the stock’s price drops.
What Type of Investor Should Use This Approach?
Every investor uses a different strategy. Fundamental analysis is a good tool, but it depends on your preferred approach.
For instance, say you’re a growth-focused investor who’s interested in what a stock or company will do over a long period of time. If you’re focusing on fundamentals to determine what to invest in, you might be more interested in how a company is projected to grow over time.
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If you’re a value investor though, you might be more interested in finding a stock that’s a great buy. Your fundamentals focus may lean toward finding stocks that have better-than-average dividend yields and low P/E ratios. This kind of strategy is all about finding companies with solid fundamentals that the market undervalues.
The right fundamental analysis for you all depends on whether you choose stocks based on growth or value. Remember, it’s not the only strategy for analyzing stocks. Conducting a technical analysis of stocks can also be helpful in shaping your portfolio.
The Bottom Line
Taking a closer look at the fundamentals can tell you a lot about a stock. If done correctly, fundamental analysis may help boost your returns and minimize volatility in your portfolio. Be mindful though, like any other stock investment strategy, it’s not foolproof. Any time you invest in the market, it’s important to remember that there’s a certain level of risk involved. Take time to understand what works best for your financial situation.
How to Analyze a Stock
If you’re ready to buy your first stock but aren’t sure how to find the best opportunities, we’ve got you covered.
When investing in a stock, your goal should be to pay a price that’s less than the value of the company’s future profits.
Unfortunately, predicting any company’s future profits and future growth with accuracy is easier said than done. After all, if we had a crystal ball to predict the future revenue and earnings of every publicly traded company, getting rich would be easy!
So, we use the next best thing when investing in the stock market: analyzing stocks.
Stock analysis helps investors find the best investment opportunities at a given time. By using analytical methods, we can attempt to find stocks trading for a discount to their intrinsic value, and therefore will be in a great position to capture market-beating returns in the future.
Image source: Getty Images.
Fundamental vs. technical analysis
When it comes to analyzing stocks, there are two basic ways you can go: fundamental analysis and technical analysis.
- Fundamental analysis is based on the assumption that stock prices don’t necessarily reflect the true intrinsic value of the underlying business. Fundamental analysts use valuation metrics and other information about a company’s business in order to determine whether a stock is attractively priced. Fundamental analysis is the best choice for investors looking for excellent long-term returns.
- Technical analysis generally assumes that a stock’s price reflects all available information and that prices generally move according to trends. In other words, by analyzing a stock’s price history, technical analysts believe you can predict its future price behavior. If you’ve ever seen someone trying to identify patterns in stock charts or discussing moving averages, for example, that’s a form of technical analysis. Technical analysis is often used by short-term traders in search of quick profits, but is generally not well suited for long-term investors. Trading stocks based on technical analysis involves a great deal of risk.
One important distinction is that fundamental analysis is typically intended to find long-term investment opportunities, while technical analysis is often geared toward profiting from short-term price fluctuations.
We generally are advocates of fundamental analysis and believe that by focusing on great businesses trading at fair prices, it’s entirely possible to beat the stock market over time. Technical analysis certainly has its place, but we strongly believe that fundamental analysis is the best way to find great long-term investment opportunities.
5 metrics to use in your stock analysis
With that in mind, let’s take a look at five of the most important and easy-to-understand metrics you should have in your analytical toolkit:
- Price to earnings (P/E) ratio — Publicly traded companies report their profits to shareholders as earnings per share, or EPS for short. If a company earned $10 million and has 10 million outstanding shares, its EPS would be $1.00 for that time period. The price-to-earnings ratio, or P/E ratio, is a company’s current share price divided by its per-share earnings, typically on an annual basis. For example, if a stock trades for $30.00 and the company’s earnings were $2.00 per share over the past year, we’d say it traded for a P/E ratio of 15, or “15 times earnings.” This is the most commonly used valuation metric in fundamental analysis, and is most useful when comparing companies in the same industry with similar growth prospects.
- Price-to-earnings growth (PEG) ratio — This metric takes the P/E ratio a step further. Different companies grow at different rates, so it’s important to take this into consideration. So, the PEG ratio takes a stock’s P/E ratio and divides by the expected annualized earnings growth rate over the next few years. For example, a stock with a P/E ratio of 20 and 10% expected earnings growth over the next five years would have a PEG ratio of 2. The idea here is that fast-growing companies can be “cheaper” than slower-growing companies, even if their P/E ratio makes them look more expensive.
- Price-to-book (P/B) ratio — A company’s book value is the sum of the value of its assets. Think of book value as the amount of money a company would theoretically have if it shut down its business and sold everything it owned – tangible property as well as things like patents, brand names, etc. The price-to-book, or P/B ratio, is a comparison of a company’s stock price to its book value. Like the P/E ratio, this is most useful for comparing companies in the same industry that have similar growth characteristics and should be used in combination with other valuation metrics.
- Return on equity (ROE) — One of the most commonly used profitability metrics, return on equity or ROE is calculated by dividing a company’s net income by its shareholders equity (assets minus liabilities). In a nutshell, ROE tells us how efficiently a company is using its invested capital to earn a profit, and like most metrics, is useful for comparing companies in the same industry. In other words, you could consider a company with a 20% ROE to be more efficient at generating a profit than one with a 10% ROE.
- Debt to EBITDA — A company’s financial health should also be taken into consideration when analyzing its stock, and one good way to gauge financial health is by looking at the company’s debts. There are several debt metrics you can use, and the debt-to-EBITDA ratio is a good one for beginners to learn. You can find a company’s total debts on its balance sheet and its EBITDA (earnings before interest, taxes, depreciation, and amortization) on its income statement. There’s no set rule in regards to how much debt is too much, but if a company’s debt to EBITDA is significantly higher than its peers, it could be a sign of a higher-risk investment.
Looking beyond the numbers to analyze stocks
It’s also important to understand that there’s more to analyzing a stock than just looking at valuation metrics. After all, it’s far more important to invest in a good business than a cheap stock. With that in mind, here are three other essential components to stock analysis that you shouldn’t overlook:
- Durable competitive advantages — As long-term investors, we want to know that a company will be able to sustain (and hopefully grow) its market share over time. So, it’s important to try and identify a durable competitive advantage — also known as an economic moat — in the company’s business model when analyzing potential stocks. This can come in several forms. Just to name a few possibilities, a well-known brand name can give a company pricing power, patents can protect it from would-be competitors, or a large distribution network can give it a cost advantage over peers.
- Great management — It’s tough to overstate the importance of great management. It doesn’t matter how good a company’s product is or how much growth is taking place in an industry if the wrong people are making the key decisions. Ideally, the CEO and other main executives of a company will have successful and extensive industry experience and will have their interest aligned with shareholders through equity-based compensation and/or large positions in company stock.
- Industry trends — Long-term investors should focus on industries that have favorable long-term growth prospects. For example, there’s a clear trend toward online retail sales. Over the past decade or so, the percentage of retail sales that have taken place online have grown from less than 5% to more than 11% today. So, e-commerce is an example of an industry with a favorable growth trend. Cloud computing, payments technology, and healthcare are just a few other examples of industries that are likely to grow significantly in the years ahead. This can be helpful in determining which industries you should focus on (and avoid) in your analysis.
A basic example of stock analysis
Let’s quickly look at a hypothetical scenario. We’ll say that I want to add a home-improvement stock to my portfolio and that I’m trying to decide between Home Depot (NYSE:HD) and Lowe’s (NYSE:LOW) .
First, let’s take a look at some numbers. Here’s how these two companies stack up side by side in some of the metrics we’ve discussed:
How to analyze the financial news?
Thursday, July 20, 2020
Retail traders like us try to speculate on short term price movements or momentary market volatility to earn high profits. There are two schools of analysis, technical analysis involving charts and mathematical calculations or fundamental analysis, using events like central bank meetings, interest rate decision, inflation data and headline news. There are many fundamental factors that affect the price of an asset and trading these events can make solid profits. The fundamentals of a currency pair or other financial asset can be learned and mastered pretty quickly. In this class, we will learn what these fundamental factors are and how they we can use this information to enter the markets successfully.
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Analysis of Financial Statement of a Company
May 26 2020 Written By: EduPristine
One of the major aspects while taking a right investment decision is to analyze the financial statements of any company. Financial Statement analysis is a process to select, evaluate and interpret financial data in order to assess a company’s past, present and future financial performance. Various questions about the company like whether it has debt repaying capacity, is it financially sound or stressed, does it have an apt financial mix, is it rightly placed to provide returns to shareholders, revenue generating efficiency, working capital management being among the major ones which can be analyzed to a larger extent through financial reports. Although the information used is historical, the purpose is to arrive to future forecasts and an estimated performance of the company.
Methods of Financial Statement Analysis:
Academically, we are all aware of common size analysis which is restating the financial information in a standardized format. This could be done by horizontal analysis which compares two or more years of financial data in both Rupee and percentage form and vertical where each category of accounts on the balance sheet is shown as a percentage of the total accounts. This can be complimented with the DuPont model and also ratio analysis. Furthermore, we then use relationships among financial statement accounts, forecasting the company’s future income statements and balance sheets, to see how the company’s performance is likely to evolve. This step is normally based on the guidance given by the company management.
Users of Analysis:
Financial analysis is carried out by investors, regulators, lenders and suppliers to decide whether to invest in a particular company, whether to extend credit to it or no. The management of the company also carries out financial analysis to evaluate the current performance and implement strategies for the future. A thorough financial analysis of a company is examining its efficiency in putting its assets to work, its liquidity position, its solvency and its profitability.
To start off, the annual report of the past 3-5 years of the company is to be acquired. The various components of the annual report add to the conclusion drawn on the company. The different parts of the financial statements need to be scanned for abnormalities, and if any found, reasons for the same are to be chalked.
The revenue model is an outcome of the reported income statement. The past data has to be seen to model growth of the company. Consistency is preferred to swings in the statement. Erratic movements build suspicion. The expense part of the model should have percent to sales calculated, like percent of cost of goods sold over sales, general and administrative expenses over sales to mention a few. This also helps in determining a spending trend, reflecting the strategy of the company. Further, non-recurring and non operative expenses also need to be analysed for concluding the earnings quality. One of the major expense that needs to be calculated is the cost of raw material and that too after taking the adjustments (increase/decrease) of inventory. The operating ratio which in common parlance is known as EBIDTA is also the key as it truly reflects the management efficiency in controlling costs. It also depicts the effective utilization of the installed capacity.
It is a reflection of what the company owns and owes. The balance sheet stands on the three important pillars that indicate the quality of investments, namely working capital adequacy, asset performance and capitalization structure. The major components of the balance sheet; under the scanner are the assets, liabilities and equity.
Assets, or the means used to operate the company, are balanced by a company’s financial obligations along with the equity investment brought into the company and its retained earnings. Assets are what a company uses to operate its business, while its liabilities and equity are two sources that support these assets. The various components of each like Assets: Current Assets (Cash and Cash equivalents, accounts receivables and inventory) and noncurrent (tangible and intangible assets), Liabilities: current (will come due for payment in a years’ time) and long-term (more than a year of repayment), also need to be analysed for any abnormalities which could be an indicator for the future projections. Reasons for the growth or slowdown seen in these individual numbers are also to be registered.
Equity represents what shareholders own, so it is often called shareholder’s equity. One needs to analyze whether the company has issued new shares or done a buyback. We need to closely see how a company puts the retained capital to use and how a company generates a return on it. These figures depict the long term strategy of the company. Also the higher the part of owners’ equity in comparison with debts, the more the company is financially autonomous, therefore solvent.
Cash flow analysis:
Cash flow statement actually depicts how the cash is generated and used in the business of the company. This is what actually interests the investors to take a call on the company. The (total) net cash flow of a company over a period is equal to the change in cash balance over this period: positive if the cash balance increases (more cash becomes available), negative if the cash balance decreases. The total net cash flow is the sum of cash flows that are classified in three areas which also need to be individually researched namely Operational Cash Flow, Investment Cash Flow and Financing Cash Flow.
All the above discussed financial statements finally help build the ratios of the company for final analysis. Different ratios across various categories like liquidity ratios, leverage ratios, profitability ratios, efficiency ratios help in analysing the overall health of the company. The trend across each shall help indicate any favorable or unfavorable numbers reported by the company. These ratios can also be compared with the data across other companies in the same industry as well.
Besides these majors points to be studied, there are other factors which also throw some light on the business, strategy and positioning of the company.
One needs to see if the dividend policy of the company supports its strategies. Like a growing company would retain the earnings to reinvest into the business rather than distributing to the investors. This is also an indicator of the future strategies of the company.
One of the key elements in fundamental analysis is management discussions and analysis section of the annual report which portrays the management style of doing business. It provides investors with insights into how the business has performed in the past, its current financial condition as well as projections of future performance. It gives a view of the management on growth and strategy, challenges and opportunities, historical performance and future outlook, financials and investments to mention a few. This definitely helps in building an opinion on the company. But one should keep a note that although it does give an insight of the management minds, it’s a thought, not audited.
Notes to accounts:
These are the footnotes to all financial statements of a company. One needs to read them very carefully as it gives lot of information as regards to the accounting methods that have been followed in preparing the accounts like inventory calculations (Lifo,Fifo,Weighted average), method of depreciation provided to mention a few. Reading of this part is also important at it gives detailed discussion on the contingent liabilities the company is facing and they are not provided in the accounts as they have yet to fructify in concrete terms.
Stock market data:
The company’s’ stock price also indicates to a great extent what the researchers feel about the company. Reactions of the market towards the moves of the company also help in drawing conclusions on a broader scale.
Financial analysis determines a company’s health and stability, providing an understanding of how the company conducts its business. But it is important to know that financial statement analysis has its limitations as well. Different accounting methods adopted by different firms’ changes the visible health and profit levels for either better or worse. Different analysts may get different results from the same information. Hence, we must conclude that financial statement analysis is only one of the tools (although a major one) while taking an investment decision.
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