Chances are you have already looked at a company’s financial situation scraping through the internet before considering investing. If you had a positive feeling, you invested. This act is fundamental analysis, in an oversimplified way. But let’s answer what is fundamental analysis properly in brief.
At its’ core, fundamental analysis helps you decide what to buy—gathering insights from various resources and reaching an intrinsic value of a stock. When the stock price drops below intrinsic value, you buy. If it’s above, you sell.
Right now, you might have questions like… how do you put an intrinsic value on a stock? When is fundamental analysis helpful? We’ll cover it all in this post.
A Comprehensive Review Of Fundamental Analysis
Fundamental analysis explores the social, political, and economic indicators that measure a stock’s intrinsic value. It also involves critically examining a business’s fundamental financials that might affect its stock price and performance. The ultimate goal should be to determine whether the stock is overvalued or undervalued. Informed investors can profit from predicting future stock price movements using this method.
But there’s another side to making money in the stock market. That is the market behaving the way you predicted. And often it does not. That’s why analysts take many factors into account for fundamental analysis.
It includes metrics such as historical data to determine the company’s performance patterns for products and competitors’ problems. Publicly available data about the company provides management statements, earnings per share, price to book ratio, dividend payout ratio, financial statements, profit margin, and what other people are saying about it. And finally, knowledge that is not publicly available, such as how management handles crises and doing background checks.
Most investors look at a company’s earnings report as the primary data point. It provides a brief assessment of how the company is performing and whether or not its profits are constant. Consistent profit growth leads to greater stock prices and dividends. However, a decline in earnings can result in a stock’s value crashing.
An investment in a company with sound fundamentals creates wealth. One can separate an investment-grade company from a junk company using fundamental analysis.
The stock market is full of high and low-quality stocks. As investors, it is your responsibility to determine the difference between weak and strong stocks. Fundamental analysis is a strategy which long-term investors use to separate strong from weak.
Types Of Fundamental Analysis
The problem in understanding fundamental analysis is that it can apply to any aspect of a company’s financial health. They can contain things like revenue and profit, but they can also include things like a company’s market share or managerial quality. Analysts typically examine these throughout months, giving an idea of how a company is run.
The various fundamental factors are grouped into quantitative and qualitative categories. Inherently, neither qualitative nor quantitative analysis is superior. Many experts think of them as a unit.
Quantitative fundamentals deal with measurable characteristics of a business. It can be anything quantifiable, represented by numbers. The biggest source of quantitative data is financial statements, revenue, financial ratios, market capitalisation, interest rate policies, and earnings per share. These can be measured with great precision.
The cash flow statement is also critical. It represents cash entry and exit over a time frame of the business. Unlike other statements, cash flow is hard to manipulate.
You can then have visual data representing the business through graphs, statistical models, and charts. These are then used to determine and compare how profitable a particular industry is.
Maybe you have a lot of Tesla stocks. There’s this new technology that surpasses electric vehicles in every way. You now know for sure that your company is going to suffer. No one needs electric cars anymore. Now you’re going to sell the stocks without due.
How do you quantify this? You can’t. It’s a realisation and this is an example of qualitative analysis.
Qualitative fundamentals are less tangible. It involves factors like management efficiency, brand recognition, company executives, labour relations, research, and patents. Overall, it represents the quality of the business.
Another consideration is the company’s governance. You need to be aware of its business practices if they are ethical and lawful.
4 Common Ratios For Fundamental Analysis
While these ratios are beneficial, they are just tools. In real life, they are considered along with various other information. These numbers can serve as a yardstick to help evaluate between different stocks.
1. Earnings Per Share
Feature: Profit assigned to each stock. It shows a company’s health. Despite making a profit, a company’s EPS may be lower.
Formula: Net Income / Number of Shares Outstanding.
Comments: If a company A makes $10 and has 2 shares its EPS is 5. Another company B makes $20 and has 5 shares; its EPS is 4. Although B makes more money, it’s likely that B provides less profit to investors, because of lower EPS
Feature: Company’s pay-outs to its stock price. You can use this to determine whether a stock is profitable for the amount you pay.
Formula: Share Price/ Earnings per Share.
Comments: If a company’s share price is $10 and EPS is 2 then P/E ratio is 5. In comparison to the stock price, a lower P/E ratio indicates the prospect of larger earnings and vice versa.
Feature: Shows relative proportion of equity and debt of a company.
Formula: Liabilities / Shareholder Equity.
Comments: 1-1.5 is considered a good D/E ratio.
4. Return On Equity
Feature: Measures financial performance of a company. It also demonstrates a company’s efficiency in generating returns on the investment of its shareholders.
Formula: Net Income / Shareholder Equity
Comments: An ROE of 15% to 20% is deemed good.
While these ratios are very helpful, they are just tools. They should be considered along with various other information. These numbers can serve as a yardstick to help evaluate between different stocks
Criticism Of Fundamental Analysis
Fundamental analysis can help you learn about the various complexities of the stock market. It can be favourable if you put money into a stock for the long term.
However, it requires intense research. And like any other strategy, it’s not always successful. Yes, numbers don’t lie, but you never know how the market reacts. Did you predict the blockade of the Suez Canal?
- Useful for long-term investments.
- Provides a comprehensive overview of a company’s financial elements.
- Quantitative analysis aids in the elimination of biases when making investing decisions.
- Lots of information available thus susceptible to information paralysis.
- No certainty if an investor has undervalued or overvalued stock
- Qualitative analysis necessitates being subjective since all information aren’t quantifiable
Now you know what is fundamental analysis and the things surrounding it. To recap, fundamental analysis is a valuable means for determining whether or not it is a good time to buy stocks. However, filtering out essential information and ignoring bogus promises should be a skill for investors.
Unfortunately, not everyone possesses this skill. But we’re here to help. Feel free to contact us if you want to have high returning stocks in your portfolio for the long term.