In this article, we will be studying the topic “What Is Fundamental Analysis (FA)?”. Also, we will look at the topic’s relationship with indicators, a company, investments, stocks, markets, etc.
This is a procedure of making research on the value of a given item with the help of indicators. Technologies, teams and the level of growth can also be of help to making fundamental analysis. The indicators are very vital in this study. There are people that use the above mentioned tools as a strategy for investment.
Fundamental Analysis: A Complete Guide
Definition Of Fundamental Analysis
Fundamental analysis helps us to access the inner worth of a stock product. However, this inner worth takes a very long time before it changes. It comprises of financial statements, external influences, events, and industry trends. Fundamental analysis considers economic factors both major and minor ones. It enables us to find out the major attributes of a company as well as analyzing its value.
They usually apply three sets of data:
- Historical data: helps to checkmate the condition of market years ago.
- Public information: this includes people’s opinion on the company, announcements made by the management, etc.
- Private and useful information: this involves the approach of resolving crisis and other situations by the leaders.
Fundamental analysis checks many features similar to stock when it comes to analyzing the stock market. Those features are listed below:
- The performance of all the organizations which the company participates in.
- The internal background for politics.
- The important agreements on trade and non-domestic politics.
- The statements made by the company regarding finance.
- The press releases made by the company.
- Similar press releases to the company and its business.
- Analysis made by the competitor.
It is detrimental when a company’s fundamental indicators show a negative data. Conversely, it will be very beneficial if it gives a positive impact.
Types of Fundamental Analysis
There are two main types of fundamental analysis. They are:
- Qualitative: This is a study of the value of the brand, management decisions, the performance of the company in terms of finance, etc.
- Quantitative: This type of analysis focuses on the company’s financial statements and it relies on numbers. It also draws conclusion from the share price of the observations.
Their methods of approach differs but the are very important in making an analysis that’s understandable.
Fundamental analysis has two methods of approach. They include: Top-down and bottom-up.
The top-down approach considers the economic factors that are major before facing the specific company. Conversely, the bottom-up approach looks into the company. It later checks how the major economic factors affects the company’s performance.
Basics of Fundamental Analysis
Below are the basics of fundamental analysis you need to consider before anything is done:
- The structure and revenue of a company.
- Total profits made over the years.
- Revenue growth over the years.
- The debt owed by a company.
- Corporate governance.
- Level of turnover in observation.
Before conducting a fundamental analysis of any stock, six of them must be put to consideration. It helps to determine its internal worth.
Methods Of Applying Fundamental Analysis on a Stock
The following steps will guide a beginner on conducting fundamental analysis of a company:
- Make sure you are familiar with the company’s operations, business model, etc.
- Make sure you use financial ratios for initial screening.
- Go through the financial reports of the company carefully.
- Research and observe those that oppose the company’s affairs.
- Compare the debts owed by the company to its opposition.
- The prospects should undergo analysis too.
Advantages and Importance of Fundamental Analysis
A company doesn’t always trade at its fair price, so fundamental analysis helps a trader access this fair price. It is often more or less.
Also, it helps to determine the future trends of assets in the market. It is generally for the purpose of long term investments. Fundamental analysis helps in predicting the long-term trends in the market. It is generally used for long-term investments. It also enables traders to identify companies with a strong growth potential suitable for investment.
Additionally, business keen insight is one of the most urgent factors but it’s not physical. It predicts the future of businesses in terms of investment. However, fundamental analysis provides all without much stress.
Comparison Between Fundamental Analysis and Technical Analysis
These two words are usually mistaken for one another. It confuses a lot of investors. Let’s check their comparison.
Fundamental analysis of a company helps to predict the flow of money in a company. This relies on how the economy, industry, and the company will perform. Thereby knowing the future value of stocks.
Technical analysis rather checks the market’s price and trading volume. Its major aim lies on detecting patterns and trends that will occur again. By this way, the traders focus more on those areas.
Summary of the Comparison
Fundamental and technical analysis are two major factors of entering trades. But the two of them are totally different from each other. Investors and traders use both to research and predict the stock prices. Both of them equally have benefits and flaws just like any other investment strategy.
This analyzes stocks by trying to measure their internal value. Fundamental analysts makes their research from general economy and situations of an industry. They extend it down to the financial strength and management of private companies. They also examine the company’s earnings, expenses, assets, and liabilities.
Here, traders analyzes stock by trying to look at its price and volume. They mainly assume that all the common fundamentals are on the basis of price. Therefore, they consider it futile to consider them. Unlike the fundamental analysts, they rather use the stock charts to discover trends. This trends in turn suggests the future behaviour of stocks.
Here are the most common indicators for technical analysis: simple moving averages (SMA), support and resistance levels, trend lines, and momentum indicators. They are further explained below:
Simple moving averages
The are indicators, that help assess the stock’s trend by calculating the average of a daily price over a specific time. When a short-term moving average intercepts a longer term moving average, it generates a buy and sell signals.
Support and resistance
The make use of price history. Support is known as areas where buyers place their orders. On the other hand, resistance is the areas where sellers place their orders as well. Those that practice trading usually buy at support levels and sell at resistance levels.
The are similar to support and resistance, they also detect definite areas to enter and leave the market. But their difference lies on how previous trades has been made. They usually come in play when stocks acquires new highs or lows respectively in the absence of price history.
Examples of momentum-based indicators are Bollinger Bands, Chaikin Money Flow, stochastics, and moving average convergence/divergence (MACD). Each of them offers buy and sell signals on different situations. They equally have unique formulas. They are used in ranging markets.
- Fundamental analysis analyzes stocks by trying to measure their internal worth.
- Technical analysis analyzes stocks by checking its price and volume.
- Fundamental and technical analysis are used for researching and predicting trends in stock prices.
Most Common Indicators used for Fundamental Analysis
Now let’s discuss the indicators used for fundamental analysis. There are different indicators that can serve this purpose. However, the most popular ones drive towards growth, earnings, and market value. When you understand these indicators properly, where to buy and sell seize to be an issue.
1. EARNINGS PER SHARE (EPS)
This is the part of income given to each share of the company’s stock. Most importantly, it is the main net income in terms of per share. Increase in EPS gives more value to the shares that investors hold.
How do I calculate EPS of a company? One may ask. Just divide the total profit by the number of available shares. If the company records a profit of $350 million with 100 million shares available, the EPS becomes $3.50.
2. PRICE TO EARNINGS RATIO (P/E)
This determines the relationship between the stock price of a company and its EPS. It also enables investors to know when the value of a stock gains hype or not. This is relative to other stocks in the same sector. The price to earnings ratio shows the income to be made from the market via previous and later earnings. Investors use this chance to compare the P/E ratio of a stock to those of its competitors and industry standards. The lower the ratio, the more beneficial the stock is to investors.
You get the P/E ratio by dividing the current price per share of a stock by the company’s EPS. If a company’s stock currently sells for $70 per share with an EPS of $5, the P/E ratio will becomes 14.
There are two main types of PE ratios. They include: the forward-looking ratio and the trailing PE ratio. The difference between the two types lies in the types of earnings that applies in the calculation. Forward- looking ratio appears when the given future earnings of 1 year serve as the denominator in the calculation. But when the past earnings are in consideration, it results to the trailing PE ratio.
3. PROJECTED EARNINGS GROWTH (PEG)
The P/E ratio doesn’t involve a future earnings growth despite being beneficial. But the expectations of the growth rate of this future earnings by the PEG breaks this limitation. Well, fundamental analysts can estimate the future growth rate of a company through their historical records. This provides a more complete illustration of the value of stocks. Let’s look at method of approach when calculating the Projected Earnings Growth. Just divide the P/E ratio by the company’s 12-month growth rate. You don’t consider the percentage in growth rate while calculating.
For example, if the growth rate is 10% and the PE ratio is 15, then the PEG formula will be:
PEG = PE Ratio / Earnings Growth
PEG = 15 / 10. You ignore that percentage sign and write as simply 10
PEG = 1.5
The general rule of thumb says:
PEG > 1 = Overvalue
PEG < 1 = Undervalue
4. FREE CASH FLOW (FCF)
This is simply the cash left over after the payment of operating expenses and capital expenditures by a company. Cash is very necessary in sustaining and making a business better. Businesses that have higher free cash flow can improve shareholder value, creates funds in a better way. They can also face challenges better than those with smaller liquidity. When a company funds its operations and pays for expenses about the capital, it is usually not easy to know if there is sufficient balance. Well, FCF helps to solve this issue which is why investors like using it for fundamental analysis. Also, why it is important to know about the balance is because shareholder’s rewards are gotten from there. This rewards are given in form of dividends.
To calculate FCF, just subtract Capital Expenditures from Operating Cash Flow. This is written in the cash flow statement. It can also be gotten from the following calculation:
FCF = Net Operating Profit After Taxes (NOPAT) + Depreciation – Working capital and capital expenditure (CAPEX). Let’s check the statement and formulas below. Here we are going to calculate the 2015 FCF:
NOPAT = EBIT – Tax
NOPAT = 1,105 – 332 = 774
FCF = NOPAT + Depreciation – (Working capital and CAPEX)
Therefore; FCF = 774 + 50 – (120 + 30) = 674
5. PRICE TO BOOK RATIO (P/B)
This can be known as the price to equity ratio. It records the comparison between the book value of a stock and its market value. Through this comparison, P/B helps investors determine if the stock is given more or less its book worth. To calculate it, just divide the stock’s current closing price by the book value per share as it is seen in the list of the company’s annual report. To calculate the book value, subtract liabilities from the total cost of all assets. Theoretically, it is the value of a company if liquidation will occur.
However, the price-to-book ratio of a particular company is dependent. An investor has to compare a company’s P/B ratio to others within the same sector to make it fully beneficial.
6. RETURN ON EQUITY (ROE)
This indicates the rate of dividends a shareholder receives for their own part of investment. It checks whether a company gives a significant returns to its shareholders in terms of investment. Most importantly, it is good to separate a shareholder’s profit because profit is the key factor of price actions in stock. It signifies the financial well-being of a company and fair value of its stock. To calculate Return on Equity, just divide the net income by average shareholders’ equity.
Furthermore, the DuPont analysis adds several variables to the calculation. This is to help investors understand more about how the company makes profits. The analysis considers the following components:
- ROA = Net Income / Assets, which can be further broken down into:
- Profit Margin = Net Income/Revenue
- Turnover Ratio = Revenue/Assets
- Leverage = Assets/Equity
Below are the formulas brought by the DuPont analysis on the calculation of ROE:
- ROE = Profit Margin x Turnover Ratio x Leverage
- ROE = Net Income/Revenue x Revenue/Assets x Assets/Equity
It shows whether it is a high-profit margin or very quick turnover ratio or high leverage that moves the ROE.
7. DIVIDEND PAYOUT RATIO (DPR)
Most companies pay some portion of their profits to shareholders as dividends. It is also necessary to understand how the company’s earnings support those dividend payments. This is the work of DPR, it clearly shows you the part of the net profit which a company pays its shareholders. It also indicates the amount the company keeps for growth, cash reserve, and repayment of debts. To calculate the dividend payout ratio, just divide the total dividend amount by the company’s net income at the same time. You usually calculate it as yearly percentage.
8. PRICE TO SALES RATIO (P/S)
This helps to calculate the fair value of a stock by making use of the market capitalization and revenue of a company. It shows the level of value that a market gives the company’s sales. This can also helps an investor to give values to growth stocks that doesn’t yield profits yet. Even those performing beyond expectations due to a temporary issue. To calculate the P/S, just divide the sales per share by the market value per share. The higher the P/S ratio, the less beneficial it becomes to investors. It is an important factor to consider when comparing companies in the same sector.
9. DIVIDEND YIELD RATIO
This considers the amount of dividends a company pays every year relative to its share price. This dividends are the only returns of a stock investment. If dividend remains constant, then the yield is inversely proportional to the stock price. This helps investors to know the amount of returns gotten from every dollar of their investment in a company’s stock. Therefore it’s very necessary.
To calculate the dividend yield ratio, just divide the annual dividend per share by the current share price. The result should be in percentage form.
For example, 2 companies pay an annual dividend of $3 per share. The first company’s stock trades at $60 per share, while the other one trades at $30 per share. This means that the dividend yield of the first company is 5% and the dividend yield of the second company is 10%. Apart from equality of dividends, an investor would likely choose the company with higher dividend yield which is the second company.
10. DEBT-TO-EQUITY RATIO (D/E)
This calculates the relationship between the capital a company borrows and the ones that shareholders provide. It helps investors to the method a company applies while funding its assets. It also signifies how the shareholder’s equity can serve creditors in times of financial struggles. This is known as checking financial leverage of a company.
To calculate debt to equity ratio, just divide the total liabilities by the total shareholder equity. The consolidated balance sheet below shows a record by Apple Inc. It is a total of $241 billion in liabilities and total shareholders’ equity of $134 billion.
According to the sheet below, Debt-to-equity ratio = $241,000,000 ÷ $134,000,000 = 1.80
Apple Inc. Balance Sheet | Source: Investopedia.
All the fundamental analysis indicators have their own significance in one way or the other. Note that there many factors that affect the prices of stock even though they help to determine the value and growth potential. This factors are difficult to measure which is the reason behind the combination of other tools with fundamental analysis. Examples of such tools are technical analysis, macroeconomic news, and industry-specific data. This gives a better illustration of your interests in the stock market. Even as you use the indicators as your standard of measurement for the worth of investments with great potentials.