There are two common practices when it comes to analyzing and choosing stocks. The two techniques are called fundamental analysis and technical analysis. Each technique has its own strengths, and how and when to deploy each method is based on personal style.
In this in-depth guide, we’ll discuss the topic “what is fundamental analysis?” and explore how millions of traders and investors around the world use it to their advantage.
What Is Fundamental Stock Analysis?
Fundamental analysis for stocks is a technique of measuring a security’s intrinsic value by analyzing related financial and economic factors.
Investors who use fundamental analysis study everything that can affect the stock’s value, from microeconomic factors like changes in the company’s management to macroeconomic factors such as industry conditions and the state of the economy.
The goal of fundamental analysis of stocks is to arrive at a number that the investor can compare with the stock’s current price. Then, they can see if the stock is currently overvalued or undervalued.
In summary, fundamental analysis is used to determine a stock’s real or fair market value.
What Is the Main Assumption of Fundamental Trading Analysis?
Investors who deploy a fundamental analysis assume that the market does not always value all stocks correctly. This assumption differs from the efficient market hypothesis, which assumes that all stocks are accurately valued at all times.
What Is Trading Fundamental Analysis Used For?
Institutions and investors deploy fundamental analysis to get a more accurate picture of a company’s intrinsic value. Intrinsic value refers to the true underlying worth of a company rather than its market value.
Traders who use fundamental analysis instead of technical analysis believe that the price of a security isn’t always an accurate gauge of the company’s value.
With fundamental analysis, investors can identify a stock they believe is undervalued compared to its current price. They can then invest in the stock in hopes that the price will rise as the company’s value becomes more apparent to the market.
On the other hand, investors can also use fundamental analysis to sell a stock they’ve been holding when fundamental analysis tells them that the market now overvalues the security.
Fundamental Analysis vs. Technical Analysis
As mentioned earlier, fundamental analysis is based on the premise that the market doesn’t always correctly value all stocks. Investors who use fundamental analysis of stock market trends try to identify and purchase companies that are undervalued.
What about when it comes to how to do technical analysis?
Technical analysis is a technique that investors use when making trading decisions based on price trends and fundamentals. This investing technique is based on the efficient market hypothesis, which is the notion that all stocks are accurately valued at all times.
As such, technical analysis also assumes that a company’s fundamentals are already accurately baked into the stock’s price. This understanding means that fundamental analysis is unnecessary if the investor assumes an efficient market hypothesis.
Investors and traders who perform technical analysis spend most of their time looking at charts, graphs, and historical data to predict where the price will move. Conversely, fundamental analysis investors evaluate company-specific metrics such as earnings growth and cash flow.
What Are the Quantitative Components of a Stock’s Fundamentals?
Let’s examine the quantitative components of a company that fundamental analysis investors use.
These fundamentals are publicly available quantitative metrics that can be used to compare different stocks within the same industry. Comparing quantitative fundamentals between stocks of different sectors is less valuable since every industry has unique norms.
Let’s discuss how to do fundamental analysis on stocks:
Earnings per Share (EPS)
Earnings per share is a metric that analyzes a company’s yearly profit, minus dividends paid, per share of its stock. In order to calculate EPS, you take a company’s net income less its dividends and divide that by the total number of shares outstanding.
EPS = (Net Income – Dividends) / # of Shares Outstanding
Price-to-Earnings (P/E) Ratio
A price-to-earnings ratio is a metric that analyzes the current price of a security in terms of its EPS. Essentially, a P/E ratio is investors’ price for one dollar of earnings per year. The share price is divided by the annual EPS to calculate this ratio.
P/E Ratio = Share Price / Earnings per Share
Price-to-Sales (P/S) Ratio
The price-to-sales ratio compares a company’s stock price to its annual revenue. However, this metric doesn’t take profit into account. To calculate a company’s P/S ratio, the share price is divided by annual sales per share.
P/S Ratio = Share Price / Sales per Share
Price-to-Book (P/B) Ratio
The price-to-book ratio compares a company’s market capitalization to its book value. Book value is found by adding up all of the company’s assets and subtracting any liabilities.
P/B Ratio = Share Price / Book Value per Share
Debt-to-Equity (D/E) Ratio
A debt-to-equity ratio compares a company’s liabilities to its shareholder equity in order to determine how its operations are funded. To calculate a D/E ratio, divide the company’s total liabilities by its shareholders’ equity.
D/E Ratio = Liabilities / Shareholder Equity
Projected Earnings Growth (PEG) Ratio
A projected earnings growth ratio compares a company’s P/E ratio to its growth rate. This metric is calculated by taking the company’s P/E ratio and dividing it by its growth rate.
PEG Ratio = P/E Ratio / Growth Rate
Free Cash Flow (FCF)
In essence, free cash flow is the cash brought in by a company’s operations less the cash it spends to maintain its operations and assets. Free cash flow takes into account the changes in working capital.
What Are the Qualitative Components of a Stock’s Fundamentals?
Although clearly defined quantitative metrics are essential and give investors a common set of analytics, fundamental analysis is much more than just numbers.
When examining a company’s fundamentals, these qualitative components are just as important as the quantitative ones.
Competitive Advantage
In a particular industry, some companies may have advantages over other companies. These advantages could be in the form of access to a particular technology, an established distribution system, or anything else.
Investors look for attributes that might cause one company to succeed over another. They ask themselves, “what does this business have that similar businesses don’t?”
Business Model
A business model defines how a company generates profit. Companies within the same industry may use different business models despite providing the same services or products.
As such, investors may prefer and value one business model over another.
Management Competence
A company’s management team plays a significant role in the growth, innovation, image, and success of the business. For this reason, investors who deploy fundamental analysis will look for company leaders with a proven track record.
Corporate Policies and Ethics
How a company interacts with the public, other companies, governments, and its employees often illustrates its ethical merits and values. As such, these factors determine how the company is viewed by its community.
Microeconomic Factors
Microeconomic factors such as supply and demand within a specific industry can impact a company’s success, so investors examine what’s happening with consumers, markets, and the industry.
Macroeconomic Factors
Macroeconomic factors also play a big role in fundamental analysis. Factors such as inflation rates and market crashes can also impact individual businesses and their shareholders.
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