Fundamental analysis is a method of evaluating a security in an attempt to measure its intrinsic value by examining related economic, financial, and other qualitative and quantitative factors.
Understanding Financial Statements
At the heart of fundamental analysis is the company’s financial statements. Here are the three main ones you need to know:
- Income Statement: This provides information about a company’s revenues, costs, and expenses, giving you the net income or the profit of the company over a specific period.
- Balance Sheet: This provides a snapshot of a company’s assets, liabilities, and shareholders’ equity at a specific point in time. Assets should equal liabilities plus shareholders’ equity; this is what’s meant when people say the balance sheet “balances”.
- Cash Flow Statement: This shows how changes in the balance sheet and income affect cash and cash equivalents. It also breaks the analysis down to operating, investing, and financing activities.
Understanding these financial statements can help you gauge a company’s financial health and profitability.
Key Financial Ratios
There are several financial ratios and metrics that investors use to evaluate company performance and financial stability. Here are a few key ones:
- Price-to-Earnings (P/E) Ratio: This is calculated as a company’s current share price divided by its earnings per share (EPS). It shows how much investors are willing to pay per dollar of earnings. A high P/E ratio could suggest that a stock’s price is high relative to earnings and possibly overvalued, whereas a low P/E might indicate the opposite.
- Return on Equity (ROE): This measures a corporation’s profitability by revealing the profit a company generates with the money shareholders have invested. It’s calculated by dividing net income by shareholder’s equity.
- Debt-to-Equity (D/E) Ratio: This measures a company’s financial leverage and is calculated by dividing its total liabilities by shareholder equity. It indicates what proportion of equity and debt the company is using to finance its assets.
- Earning ss per Share (EPS): This is the portion of a company’s profit allocated to each outstanding share of common stock. It serves as an indicator of a company’s profitability.
- Dividend Yield: This is a financial ratio that shows how much a company pays out in dividends each year relative to its stock price.
Company’s Business Model and Industry Analysis
Understanding the company’s business model—how it makes money—is crucial. It’s also important to understand the industry in which it operates and how it compares to its competitors. This involves looking at factors like industry growth trends, market share, competition, and how the company is positioned within the industry.
Finally, the broader economic environment impacts all businesses. This includes factors like economic growth, interest rates, inflation, and unemployment. For example, in an expanding economy, businesses may see an increased demand for their products, which could lead to higher stock prices.
Fundamental analysis involves a lot of data gathering, but it’s an essential part of making informed investment decisions. It helps you understand not only what’s happening with a company now, but also what you might expect in the future.