To get a sense of a commodity’s intrinsic value, experienced investors regularly conduct a fundamental analysis of stocks. This involves reviewing a given company’s financial health and historical performance and finding out how they measure up according to a few metrics.
Fundamental analysis of stocks is separate from technical analysis. The latter focuses on how a company’s share price movements and trading patterns position it in the marketplace. Reviewing the fundamentals can give investors a better idea of a stock’s long-term prospects.
In days past, this information was primarily accessible only to those in the financial and investment industries. Now it’s easier for everyday investors to see and assess the data. In this post, we look at a few quantitative and qualitative areas covered in the fundamental analysis of stocks.
Crunching the Numbers: Qualitative Factors in Fundamental Analysis
Every company traded on the New York Stock Exchange must make its financial and business information public. Most companies publish this data on their company websites. Investors can also find it on their respective brokerages’ websites and leading financial platforms like Yahoo Finance, MarketWatch, and others.
Qualitative data can seem daunting to comb through during industry analysis. However, some of the major metrics are fairly simple to explain and understand.
Financial Statements
The most logical place to start with a fundamental analysis of stocks is a company’s public financial statements. They break down into three report types:
- Income Statement: Revenue, net income, general profitability
- Balance Sheets: Assets, liabilities, and debt-to-income ratio
- Cash Flow Summaries: Liquidity of operating, investing, and financing expenses
These figures provide a snapshot of how the company functions on a daily basis. They can suggest benchmarks and areas of concern for the company to address.
Earnings Reports
Companies issue earnings reports at regular intervals — usually quarterly — throughout the year, along with a year-end annual report. The reports disclose the company’s financial performance over the given period. Earnings reports present the company’s revenue and operating expenses, arriving at a net profit or loss.
Earnings reports typically contain income statements, balance sheets, earnings per share (EPS), cash flow analysis, and company management insights. Investors use the data to label patterns and likely trends involving the stock.
Analysts use earnings reports to identify points when it’s best to enter, exit, or hold a position. Surprise gains or shortfalls can have an immediate impact on share prices.
Price-to-Earnings Ratio (P/E)
An especially key metric in fundamental analysis is a company’s price-to-earnings ratio. This figure measures the company’s share price in relation to earnings per share. It’s a simple calculation of each share’s market value divided by its earnings per share.
The P/E ratio reveals insights into the share price as it relates to actual company profits. A low P/E ratio suggests the stock may be underperforming — investors might want to snap it up at a discount. A high P/E ratio suggests the company’s value is overestimated.
Analysts use alternative ratios to get more specific information that could back up the P/E ratio. Some of these alternative valuations include:
- Price-to-Book Ratio (P/B): Compares a company’s market value to its book value per share
- Enterprise Value to EBITDA Ratio: Compares the company’s total value to its earnings before interest, taxes, depreciation, and amortization
- Price-to-Sales Ratio (P/S): Compares a company’s market value to total revenue
Debt-to-Equity Ratio (D/E)
The debt-to-equity ratio works as an assessment of a company’s financial leverage. It’s a calculation of a company’s total liabilities and its stockholders’ equity. The result is an indicator of how the company manages and takes advantage of debt financing to grow in the market.
It’s particularly important to consider the D/E ratio in the context of the company’s industry. Average D/E ratios differ from industry to industry, so it’s more useful as a way to compare the stock to others in its specific business sector.
For example, REITs, casinos, department stores, and travel services tend to have higher D/E ratios, while precious metals, biotech, insurance, and electronic companies skew lower.
High D/E ratios suggest a company runs a bigger risk, while low ones suggest the company is missing out on opportunities for debt financing. A balanced D/E ratio implies that the company is in solid financial shape, making it equally attractive to investors and lenders.
Dividend Yield
Dividend yield is a ratio in which a company’s annual dividend payments are divided by its stock price. The result is multiplied by 100 to derive a percentage, an indicator of what a company’s potential revenue stream may look like.
Income investors — those who regularly rely on dividends as a source of income — are especially interested in dividend yield. This analysis is relatively straightforward: high dividend yields are attractive, low ones much less so.
When a company that has traditionally seen dividends rise over time suddenly experiences a drop, it could be a sign of trouble. Long-established companies that are hoarding a lot of cash may also be having issues. When a company is able to sustain success, investors may prefer to reinvest their dividends into the company rather than take the quarterly payout.
Reading the Room: Qualitative Measures in Fundamental Analysis of Stocks
Qualitative factors in stock analysis can offer deeper insights into how a company operates and its long-term prospects. These factors aren’t necessarily measured with numbers. Instead, they’re expressed in terms of management behaviors, competitive advantage, and market conditions.
Here are a few of the most important qualitative factors that investors consider.
Company Management and Leadership
The importance of effective management of a company can’t be overstated. Data can’t tell the whole story. A company that over-relies on its financial statements may be concealing operational deficiencies or unseemly traits (remember Enron).
Assessing company management involves taking a look at the CEO’s length of tenure, insider buying, compensation, and long-term strategies and goals. Company leaders are the ones who drive value creation for stockholders, so excellent management is vital. Shareholders’ opinions of management’s track record may provide a snapshot as well.
Industry Analysis and Competitive Positioning
Fundamental analysis of stocks can’t be conducted in silos — it must be evaluated in context. Industry analysis takes a broader view of the trends, market growth, technological evolution, and regulations that impact an entire industry or market segment.
Analysts rely on a few modules for industry evaluations, such as Porter’s Five Forces and PESTEL analysis. They also summarize how competitive the company is in its given industry, including its market share, brand awareness, cost structure, and strategic advantages.
Market Conditions
External forces and trends heavily inform the state of the stock market. Inflation, interest rate changes, business cycles, and economic policy shifts all affect a company’s financial health. Factors like the regulatory environment and technological and market disruptions also play a role.
More broadly, geopolitical events and market sentiment can also affect share value. Understanding these macro trends — GDP growth, demographic shifts, and so forth — is crucial in investor decision-making. However, these macro trends should be examined alongside harder data to steer proper interpretation of what they may mean.
Gaining an Edge in Fundamental Stock Analysis
With all of the access to information common investors have, an organized plan for gathering fundamental data is especially beneficial. The more an investor practices to obtain, structure, and interpret these metrics, the easier it is to understand the directions share prices take. That facilitates better decision-making and potential success.
Fundamental stock analysis is a major part of the service Gorilla Trades offers. We provide our clients with solid tips on stock opportunities that could turn handsome profits. To learn more, sign up for a free 30-day trial with daily alerts.
