What is fundamental analysis?

E*TRADE from Morgan Stanley


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 fundamental analysis?

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 tell us a great deal about their businesses. These reports include the company's balance sheet, income statement, cash flow report, and other documents. They help investors gauge how well the companies are doing financially and compare them to one another.

What can fundamental analysis show?

The main goal of fundamental analysis is to determine the value of a company and the outlook for its stock.

Based on a company's fundamentals, an investor might decide that its stock is selling for more or less than it's really worth. The fundamentals may also give clues about a company's future. Does it look like it will grow and increase its profits, or is the company's future uncertain? And fundamental analysis can help you compare companies to each other to see which ones are leading their sectors and which ones are falling behind.

Using broader business and economic data, the basic ideas of fundamental analysis can also be applied to sectors, industries, and entire economies. Some investors do what's called a top-down analysis, starting with the overall economy, drilling down to industries and sectors, and then to individual stocks. The opposite approach—starting with stocks and moving up to sectors, industries, and the economy—is called a bottom-up analysis.

What are some of the key figures, or metrics, that are used in fundamental analysis?

Market capitalization (market cap)

What it means: This is the total market value of the shares outstanding of a publicly traded company. You simply multiply the number of shares by the price per share, so if XYZ Corporation has 1 million shares trading at $10 per share, the company has a market cap of $10 million.

Why it's important: Market cap is a very common way to judge the scale or size of a company. Some investors believe that larger companies may be less risky than smaller ones. Generally, companies are classified in one of three categories: large cap, mid cap, and small cap.

Earnings per share (EPS)

What it means: This is the portion of a company's profit allocated to each outstanding share of common stock. It's the company's net earnings (i.e. net profits) for a given time period divided by the number of shares of its stock outstanding. If XYZ Corporation, with 1 million shares outstanding, made $1 million in profit, its EPS would be $1.

There are different ways to measure the time periods and number of shares outstanding when calculating EPS, so make sure you know which variables were used when you're looking at an EPS figure.

Why it's important: EPS helps to show how well a company generates profits for every dollar that shareholders invest and can be a significant factor influencing a stock's price. A higher EPS number indicates greater profitability.

Investors might also look at EPS for a single stock over time to help gauge a company's trajectory. Is EPS growing from quarter to quarter or shrinking?

If a company's EPS is higher than its competitors, or on an upward trend, that may be a sign that the company can increase dividend payments or invest more to grow its business.

Price-to-earnings ratio (P/E ratio)

What it means: P/E ratio helps you see how the price of a company's stock compares to its profitability. It's calculated by dividing the stock price by EPS. Let’s use XYZ Corporation as an example again. We know that its stock is selling for $10 per share and its EPS is $1. So its P/E ratio would be 10—the stock is selling for 10X more than its earnings per share.

Why it's important:Many investors believe that P/E is a useful way to help judge whether a stock is overpriced or underpriced. It's also often used to compare the performance of stocks within the same industry or sector, helping to narrow down the choices.

Dividend yield

What it means: This shows the rate of return that a company's shareholders received in the form of dividend payments. It's the stock’s total dividend for the year divided by its price, converted to a percentage.

Why it's important: It helps investors see how much cash flow they are getting from each dollar invested in a dividend-paying stock.

Dividend yield may also give other hints about a company. Generally, stocks with less growth potential pay higher dividends, while stocks with high growth potential often don't pay any dividend at all.

One thing to remember: a company can decide to stop paying dividends, or lower the dividend, at any time.

Profit margins

What it means: This is simple enough: it's how much of a company's revenue (money collected from sales) is left over after it pays its costs and expenses. Typically, this is expressed as a percentage.

There are actually several types of profits, but two key figures that investors often look at are gross profit margin and operating profit margin.

Why it's important: Profit margins are an important indicator of how efficiently a company operates. But note that you should normally compare a company's profits only to other companies within the same sector because average margins can be quite different from industry to industry.

Debt to equity ratio

What it means: This gives a snapshot of how much a company is relying on borrowed money. It compares the company's liabilities (debts) to its equity (the value of assets remaining after debts are subtracted). You can find both of these figures easily on any company's balance sheet.

Why it's important: It may help investors judge a company's level of financial risk, with a higher debt-to-equity ratio often considered somewhat riskier.

Debt-to-equity also gives clues about a company's exposure to changing interest rates. If a firm has borrowed a lot of money, rising rates could hurt its future profitability, and vice-versa.

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.

What to read next...

Simply put, technical analysis attempts to measure the supply of, and demand for, a stock. Learn more about how you can use this technique in this brief article.

Most technical analysis is performed by observing and interpreting charts. A chart is a historical record of stock price movements plotted over a time period, like one day, one year, one decade, or even longer.

One of the assumptions of technical analysis is that history repeats in the stock market. One example of this is recurring patterns in historical stock prices. These price patterns are essentially shapes that sometimes appear on stock charts.

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