Intro to fundamental analysis
Fundamental analysis is a process used by investors to evaluate the financial health and performance of a company in order to judge whether to invest in the firm's stock. The technique relies on a company's publicly reported business information such as earnings, profit margins, debt, equity, and other data.
Why use it?
One of the major challenges stock investors face is choosing which stocks to invest in, among the thousands available in the market. Fundamental analysis is a tool that investors often use to narrow down those choices based on the financial and economic condition—the fundamentals—of individual companies.
Many investors and traders use fundamental analysis specifically to help them choose which stocks to buy, and they may use a different technique, called technical analysis, to help them make decisions about timing—i.e. when to buy or sell.
What is fundamental analysis based on?
Every three months (every quarter) publicly traded companies release financial reports that provide a great deal of accounting information about their businesses. These reports help investors gauge how well the companies are doing financially and compare them to one another. There's an important point to keep in mind: reports come out on a quarterly basis (with some exceptions), and they report past results, so there is a delay between the time the performance occurred and when it's reported. In contrast, technical analysis is based on price charts that update in real-time.
What can fundamental analysis show?
Investors take financial reports and use them to find companies that are separating themselves from the rest. In other words, the business data helps investors identify which companies are leading and which are lagging in their sectors.
It's also worth noting that you can use fundamental analysis not just on individual companies but also on sectors or industries. You can even use the techniques on the broader market, helping you evaluate the economy as a whole.
Let's take a quick look at a few of the many figures, or metrics, that are used in fundamental analysis:
Price to earnings ratio
This is the stock price divided by the company's earnings per share. If the market price of a company's stock is $20 when the firm's earnings per share is $1, then the P/E ratio is 20. Investors might use P/E ratio to make side-by-side evaluations of stocks to see which are selling for higher multiples over earnings.
This is the annual return an investor receives in the form of dividend payments and gives us another way to view the price of a stock and the performance of a company. It's calculated by dividing the annual dividend per share by the stock's price per share, then converting the result to a percentage.
Usually called market cap, this is one way to judge the scale of a company. Stocks generally fall into one of three categories: large cap, mid cap, and small cap. Market cap is simply the number of shares outstanding multiplied by the price per share. A company with 10 million shares outstanding at $50 per share has a market capitalization of $500 million. That would be considered a small cap stock.
These can help show how efficiently a company operates. There are several different ways to measure profits, but one figure that investors often study is gross margin. This is the firm's revenue minus its cost of goods sold, shown as a percentage. If a company had $500 in sales, and its costs to make or acquire its goods was $300, then the gross profits are $200, for a gross margin of 40%.
Debt to equity ratio
This compares a company’s liabilities (debts) to its equity (the value of assets remaining after debts are subtracted). The ratio gives a snapshot of how much a company is relying on borrowed money and may help investors judge the company's level of financial risk, as well as its exposure to changing interest rates. Debt to equity ratio is easy to calculate: just divide total liabilities by total shareholders equity, both of which are shown on a key report: the company’s balance sheet.
Using fundamental analysis and technical analysis together
Even if you're using fundamental analysis techniques, technical analysis can play a complementary role by helping you protect your investments when trading. In other words, investors may use fundamental analysis to narrow down the choice of stocks and compare companies side by side, while technical analysis may come into play for timing trades and managing risk.
This article just scratches the surface of fundamental analysis. Explore Knowledge for much more on fundamental analysis and other techniques for choosing and evaluating investments.