Fundamental analysis is the process of looking at a business at the most basic, or fundamental, financial level. This type of analysis takes a look at the key ratios of a business to figure out how financially healthy it is.
Fundamental analysis can also give you an idea of a company's stock trade value, compared to similar companies. The analysis should take many factors into account, including revenue, asset management, and the production of a business, as well as the interest rate.
What Is Fundamental Analysis For?
Many investors use strictly fundamental factors in their analysis of a company and its share price. Others have found that they can create a more robust model of valuation and price expectation using both fundamental and technical factors, such as relative price strength or market sentiment.
The goal is to determine whether the current price of the stock reflects a value that is different from what the fundamental factors and overall market sentiment might suggest. If such a difference is found, then there's a chance that an investment opportunity exists.
Even if you don't plan to do an in-depth analysis on your own, learning the key ratios and terms can help you follow stocks more closely and accurately.
Start by Checking the Earnings
You should consider a wide range of data, but the first data point you should look for is the company's earnings. That figure is the simplest way to get to the point of a key investing question: How much money is the company making? And how much is it likely to make in the future?
In other words, earnings are profits. They can be complicated to calculate, but that's what buying a company is all about. Lucky for investors, companies report their earnings each quarter. Analysts follow these reports closely, especially for major companies.
When a company reports that earnings are on the rise, that often leads to a higher stock price. In some cases, it also leads to larger dividends, or even the introduction of a dividend, if one doesn't already exist. When earnings fall short of expectations, the market can hammer the stock. That means traders quickly sell off their stocks because they seem to be overvalued, causing the price drop.
Fundamental Analysis Tools
While earnings are important, they don't tell you much by themselves. On their own, earnings don't show how the market values the stock. You'll need to look at more fundamental analysis tools to start to build a picture of how the stock is valued.
You can find most of these ratios completed for you on finance websites, but they aren't too hard to calculate on your own. If you want to try for yourself, keep in mind that some of the most popular tools of fundamental analysis focus on earnings, growth, and value in the market. These are some of the factors you'll want to include:
- Earnings per share (EPS): Neither earnings nor the number of shares can tell you much about a company on its own. But when you combine them, you get one of the most commonly used ratios for analysis. EPS tells us how much of a company's profit is assigned to each share of stock. EPS is calculated as net income (after dividends on preferred stock) divided by the number of outstanding shares.
- Price-to-earnings ratio (P/E): This compares the current sales price of a company's stock to its per-share earnings.
- Projected earnings growth (PEG): PEG anticipates the one-year earnings growth rate of the stock.
- Price-to-sales ratio (P/S): The P/S ratio values a company's stock price as compared to its revenues. It's also sometimes called the "PSR," "revenue multiple," or "sales multiple."
- Price-to-book ratio (P/B): Also known as the "price-to-equity ratio," the P/B compares a stock's book value to its market value. You find it by dividing the stock's most recent closing price by last quarter's book value per share. Book value is the value of an asset as it appears in the books. It's equal to the cost of each asset minus cumulative depreciation.
- Dividend payout ratio: This compares dividends paid out to the shareholders to the company's total net income, and it also accounts for retained earnings or income that is not paid out but rather held onto for potential growth.
- Dividend yield: This is the yearly dividend total compared to share price. It's given as a percentage. Divide payments per share in one year by the value of a share.
- Return on equity: Divide the company's net income by shareholders' equity to find its return on equity. You might also hear this called the company's "return on net worth."
There's No Simple Answer
Keep in mind that these numbers are just tools. No single ratio or number will give you all the information you need. They can't give you buy or sell advice by themselves. They must be weighed along with other considerations.
As you create a picture of what you want in an investment, these numbers can serve as benchmarks to help you measure and compare different companies.
Frequently Asked Questions (FAQs)
How is a technical stock trader different from a fundamentals trader?
Technical stock traders, in the purest sense, only study price action and related technical indicators like average volume and the relative strength index (RSI). In theory, a technical stock trader doesn't care what they're trading, much less the fundamental value of it, but many traders combine aspects of technical and fundamental analysis.
Why would a stock go up if it has poor fundamentals?
Someone may buy a stock with poor fundamentals if they believe it has the potential to have strong fundamentals in the future. These are often referred to as "growth stocks" because investors believe the businesses will grow significantly. A "value stock" is the opposite, and investors will tolerate slower growth because the company already has strong fundamental value.
Where can I find historical information about a stock's fundamentals?
Many publicly traded companies will offer this information in the "investor relations" section of their websites. The government also maintains a free online database that has every legally required public company filing since 1994.