The Top Tools of Fundamental Analysis
The most popular tools of fundamental analysis focus on earnings
Fundamental analysis is the process of looking at a business at the most basic or fundamental financial level. This type of analysis examines the key ratios of a business to determine its financial health. Fundamental analysis can also give you an idea of the value of what a company's stock could be expected to trade for based on a comparative appraisal of similar companies. The analysis should take several factors into account, including revenue, asset management, and the production of a business, as well as the interest rate.
Many investors use strictly fundamental factors in their analysis of a company and its share price, but others have found that they can develop a more robust model of valuation and price expectation using a combination 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 prevailing market sentiment might suggest. If such a difference is found, then perhaps an investment opportunity exists.
Even if you don't plan to do an in-depth fundamental analysis yourself, understanding the key ratios and terms can help you follow stocks more closely and accurately.
First Thing's First: Check the Earnings
Investors should consider a wide range of data, but the first data point they're likely to look for is the company's earnings. That figure is the quickest way to cut to the heart 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. Conveniently for investors, companies report earnings every quarter. Analysts follow these reports closely, especially for major companies.
When a company reports that earnings are on the rise, that generally leads to a higher stock price and, in some cases, a larger dividend (or the introduction of a dividend, if one doesn't already exist). When earnings fall short of expectations, the market can hammer the stock.
Fundamental Analysis Tools
Although earnings are important, they don't tell you much by themselves. On their own, earnings don't identify how the market values the stock. You'll need to incorporate more fundamental analysis tools to begin building a picture of how the stock is valued.
You can find most of these ratios completed for you on finance-related websites, but they aren't difficult to calculate on your own. If you want to wade in 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 identify and 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 company 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 ratio 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 price-to-sales 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): This ratio, also known as the price-to-equity ratio, compares a stock's book value to its market value. You can arrive at 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 company's books. It's equal to the cost of each asset less cumulative depreciation.
- Dividend payout ratio: This compares dividends paid out to the stockholders to the company's total net income. It accounts for retained earnings—income that is not paid out, but rather, retained for potential growth.
- Dividend yield: This, too, is a ratio—yearly dividends compared to share price. It's expressed as a percentage. Divide dividend 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 expressed as the company's return on net worth.
There Are No Magic Bullets
Remember, these numbers are just tools, and no single ratio or number is a magic bullet. They can't give you buy or sell recommendations by themselves. They must be weighed in tandem with other considerations and ratios.
What these numbers can do, as you begin to develop a picture of what you want in an investment, is serve as benchmarks to measure and compare the worths of companies.
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U.S. Securities and Exchange Commission. "Form 10-Q." Accessed Dec. 31, 2019.
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Investor.gov. "Earnings Per Share." Accessed Dec. 31, 2019.
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American Association of Individual Investors. "Earnings Estimates and Their Impact on Stock Prices." Accessed Dec. 31, 2019.
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