Knowledge is power, especially when choosing stocks to buy or sell to build a strong portfolio. One method that might help you make investment decisions is fundamental analysis. With fundamental analysis, you may be able to determine the fair market value of a stock and determine if it is a suitable stock to buy and when to buy or sell it.
Even if you’re working with investment advisors to build your portfolio, knowing the process of how to read the fundamentals of a stock can help you be a more thoughtful investor.
What Is a Fundamental Analysis?
Fundamental analysis is a method of evaluating the value of a security, such as a stock, by analyzing its financial and operational health. Fundamental analysis involves looking at a company’s financial statements, like its balance sheet, income statement, and cash flow statement, as well as other information, such as its competitive landscape and management team.
Through this process, an investor aims to discover the asset’s intrinsic value and use that information to decide whether its current market price makes it a fair buy or sell. The goal is to find a stock that is currently undervalued and may grow in value over time or to sell one that is currently overvalued.
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Generally, fundamental analysis is used more by professional analysts than individual investors, but individuals can also use it to analyze a stock since much of the data is public.
In contrast to fundamental analysis, many investors will use technical analysis to make investment decisions. Investors who use technical analysis pay attention to technical indicators, like a stock’s price movement and volume, to analyze patterns and make forecasts. Short-term traders commonly use technical analysis.
How Does Fundamental Analysis Work?
Typically, the first step in using fundamental analysis is to evaluate macroeconomic factors, such as current economic indicators and the company’s industry. Next, an investor looks at the company itself by evaluating revenues, earnings, growth potential, profit margins, competitors, management, and more.
Some metrics investors use in fundamental analysis include earnings per share (EPS) and price-to-earnings ratio (P/E), among others. These metrics help analysts see the differences of stock prices between companies and their peers. The following are examples of financial ratios used in fundamental analysis:
Earnings per Share
Earnings per share (EPS) is a financial ratio that measures a company’s profitability by dividing its net income by the number of shares outstanding. It is a commonly used metric in fundamental analysis because it gives investors an idea of how much profit a company generates per share of stock.
EPS can be a valuable tool for comparing the profitability of different companies within the same industry and a company’s performance over time. However, it’s important to note that EPS can be affected by various factors, including a company’s financial leverage, tax rate, and a change in the number of outstanding shares, so it should not be used in isolation when evaluating a company’s financial health.
Price-to-Earnings Ratio
The price-to-earnings ratio (P/E ratio) compares a company’s stock price to its earnings per share (EPS). Often, the goal is to invest in a company with a much lower P/E ratio than similar companies.
Investors can use a P/E ratio to compare companies within the same industry or similar types of investments. A high P/E ratio may reflect overvalued stocks or investor expectations of growth in the future. A lower P/E may imply the stock is undervalued relative to its earnings. And if a company has no earnings — if it breaks even or has losses — the P/E ratio will not work.
Price-to-Sales Ratio
The price-to-sales ratio (P/S ratio) is a financial ratio that compares a company’s stock price to its revenues. One way to calculate the P/S ratio is by dividing the company’s market capitalization (the total value of its outstanding shares) by its total sales over a given period, typically the past 12 months. Another way to calculate the ratio is by dividing the stock price by its sales per share ratio.
The P/S ratio is often used in fundamental analysis to evaluate a company’s financial health and potential for growth. A low P/S ratio may indicate that a company’s stock is undervalued, while a high P/S ratio may mean it is overvalued. However, a downside to the P/S ratio is it doesn’t measure a company’s current or potential earnings.
Debt-to-Equity Ratio
The debt-to-equity ratio (D/E ratio) compares a company’s total debt (also called liabilities) to its shareholders’ equity (the value of its assets minus its liabilities). The debt-to-equity ratio measures a company’s financial leverage and can be used to assess its ability to pay off its debts.
A high debt-to-equity ratio may indicate that a company is heavily leveraged and may be at risk of default if it cannot generate sufficient profits to pay off its debts. On the other hand, a low debt-to-equity ratio may indicate that a company has a solid financial position and is less dependent on borrowing to finance its operations.
Return on Equity
Return on equity (ROE) is a financial ratio that measures a company’s profitability by dividing its net income by its shareholder equity. It is a commonly used metric in fundamental analysis because it gives investors an idea of how well a company generates profits from its shareholder investments.
A high return on equity may indicate that a company is generating strong profits and may be a good investment. However, a low return on equity may suggest that a company is underperforming and may need to generate more profits to justify its share price.
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How Fundamental Analysis can Help Investors
When you buy something, you want to know that you’re not overpaying. In the same vein, analysts and investors can use fundamental analysis to help figure out whether a stock’s price is fair and attempt to maximize the profits of their portfolios.
Analysts typically give investors information about stocks to help them decide what to buy, sell, or keep. Fundamental analysis can help investors find undervalued stocks (to buy) and overvalued stocks (to sell if they own them).
Fundamental analysis is most useful for longer-term investors but can also be used for short-term investments.
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Layers of Fundamental Analysis
Analysts generally use three layers of fundamental analysis to evaluate a company’s financial health. By analyzing these three layers, analysts can get a complete picture of a company’s financial health and make informed investment decisions.
• Macro analysis: A high-level macro analysis involves considering macroeconomic factors such as economic growth, interest rate risk, and inflation that may impact a company’s performance.
• Industry analysis: This involves analyzing the broader industry in which a company operates, including industry data and trends, as well as the competitive landscape.
• Micro analysis: This involves looking at a company’s specific financial and operational data, such as its financial statements and management team.
Types of Fundamental Analysis
There are two types of fundamental analysis: qualitative and quantitative.
Qualitative Fundamentals
Qualitative fundamental analysis evaluates a company’s financial health by analyzing subjective factors that cannot be easily measured or quantified. These factors may include a company’s management team, corporate culture, brand reputation, and intellectual property. Analysts can gain insight into a company’s potential for future growth and success by analyzing these subjective factors.
Qualitative analysis is often used with quantitative research to get a complete picture of a company’s financial health.
Quantitative Fundamentals
Quantitative fundamental analysis evaluates a company’s financial performance by analyzing objective, measurable data in financial statements and market trends. This analysis uses financial ratios and metrics outlined above, such as the P/E ratio and debt-to-equity ratio, to gain insight into a company’s financial strength and performance.
Tools for Fundamental Analysis
There are several tools investors and analysts can use for fundamental analysis, including:
• Financial statements: Analysts will review a company’s balance sheet, income statement, and cash flow statement to understand its financial strength and performance. Investors can also comb through a company’s annual report to get a sense of the company’s performance during a given year.
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• Financial ratios and metrics: Analysts will use financial ratios and metrics, such as the P/E ratio and debt-to-equity ratio, to gain insight into a company’s financial health.
• Industry data and research: Analysts will consider industry-specific data to measure trends and see how a company compares to its peers. This can help determine the company’s competitive landscape, including the size and strength of its competitors, to gauge its market position and potential for growth.
• Company management and leadership: Analysts will often review the experience and track record of a company’s management team to assess their ability to run the company effectively.
• Macroeconomic data: Analysts will consider macroeconomic factors such as gross domestic product (GDP), interest rates, and inflation that may impact a company’s performance.
Fundamental Analysis Challenges
The main goal of using fundamental analysis is to find stocks currently priced less than they are worth. However, even if you buy undervalued stocks after conducting fundamental research, it doesn’t mean the stock’s price will necessarily rise to its supposed intrinsic value. And even if the stock’s price may rise to its supposed intrinsic value, it may not happen on your desired time horizon.
This is partly why fundamental analysis is more frequently used for longer-term holds, as it can take time to see the desired results — if you see them at all.
One way to avoid this problem is to use fundamental analysis to find strong companies rather than focusing on undervalued stocks. If a company is well-positioned in its industry and shows signs of future growth, it might be more likely to grow and succeed over time.
It may also be beneficial to use a combination of fundamental and technical analysis to evaluate stocks. Nonetheless, various factors, such as economic conditions and market sentiment, can impact a stock’s performance regardless of the type of analysis an investor uses.
The Takeaway
If you’re getting started as an investor, knowing which stocks to buy and when to buy them can be challenging. That’s why tools such as fundamental analysis can be valuable to learn early in your investing journey. You can begin to use fundamental analysis by first deciding what types of stocks you’re interested in buying and your goals. Once you have your goals in mind, you can narrow down the stocks that may fit your criteria. Then, you might use fundamental analysis methods and metrics to figure out which stocks are the best purchases for you.
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FAQ
How do you analyze fundamental stock data?
To analyze fundamental stock data, you can use financial ratios and metrics such as the P/E ratio, debt-to-equity ratio, return on equity, and earnings growth to gain insight into a company’s financial health, performance, and growth potential. It’s important to consider a range of factors when evaluating a stock, as no single metric can provide a complete picture of a company’s financial health or investment potential.
What are common tools used for fundamental stock analysis?
Some common tools used for fundamental stock analysis include company financial statements, industry data, and news and analysis from financial experts and market analysts.
Are stock fundamental analyses necessary?
Stock fundamental analyses can be a valuable tool for investors to decide which stocks to buy or sell. However, it’s important to note that fundamental analysis is just one aspect of investing. Some investors may use technical stock analysis, a method of evaluating stocks by analyzing data generated by market activity, such as past prices and volume, to identify trends and patterns that may indicate the security’s future direction.
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