Fundamental analysis is a investment strategy based on the idea that all decision should be based on sound arguments of financial nature. This seems common sense, however speculation in financial markets abound: contrast with Technical analysis where decisions are taken mostly based on patterns of price fluctuations.
The overall process of using Fundamental Analysis can be seen as a four step process:
- Establishing initial investment criteria followed by stock screening.
- Analyzing Financial Statements and Ratio Analysis
- Stock Valuation
- Finally deciding on whether to buy or not.
Setting investment criteria for ScreeningEdit
It is not physically possible to analyze every stock that is potentially available. So you need to think in terms what kinds of stock characteristics you want in a company. Using one of any number of stock screeners available on the internet, you can then build a list of possible prospects to analyze that will be manageable.
Analyzing a company Edit
The most important source of information for analyzing a company is the yearly financial reports. Governments require companies listed in stock exchanges to make their financial reports available to the public. The annual financial report contains the most complete picture of a company, and many companies also publish quarterly reports to supplement the year end report.
Financial reports are usually easy to obtain, either from the company web site (usually under the link investor relations), or from the EDGAR database found at the U.S. Securities and Exchange Commission (SEC) (only for the stocks listed on U.S. stock exchanges).
It should be noted that financial reports disclose information as required by law, but the company can choose to divulge the information in any way it sees fit. Financial reports must be sifted through for the facts, because they will often be obscured by colorful language and graphics.
Ratio analysis is a means by which the acquired information can be assessed. Some ratios of note would be:
- Current Ratio = Current Assets/Current Liabilities
- Return on Equity (ROE)
- Price-Earnings Ratio
- Earnings per Share
- Book Value per Share
The most important indicator of a company performance is the Earning per Share (EPS). The EPS is the company profits, over a year, divided by the total number of outstanding shares. Since a single share corresponds to the ownership of a tiny part of that company, the EPS measures the profit of that tiny part.
Obviously that the larger the EPS is, the better performance a company shows. However, care should be taken with regard with surprising high growth rates of the EPS over the years. Stability of the EPS is a very important aspect of valuing a company. Not only the last year EPS should be considered, but also the average of the EPS over the last, say, 3 or more years. Moreover, stable growth rates should take into account averages over a number of years, comparing the average ending in the last year, with the average of the same number of years, many years ago -- say 5 or 10 years.
For instance, in chapter 13 (A Comparison of Four Listed Companies) of the Benjamin Graham book " The Intelligent Investor", he analyzed the EPS of 1970. Then he takes the averages of the 1968-1970 period (3 years), as well as the 1963-1965 and the 1958-1960 periods. He then assesses the 5 year and the 10 year growth rates using these averages. See Graham company analysis grid for a full set of indicators he used in his book to scrutiny companies.
The importance of the EPS derives from its comparison with the market value of the share (quote). The ratio between the stock price and the EPS corresponds to a crucial value called P/E ratio. See below for further details. This ratio measures how many times the stock price is higher than the EPS.
The book value of a company is an accounting variable corresponding the total assets of the company minus the intangible assets (e.g. patents, goodwill) and all liabilities. The book value per share is simply this value divided by the total number of shares. If the company were to be liquidated, the book value per share would be what shareholders would theoretically receive per each share owned.
The stock price of a company can be compared with its book value per share: for instance, if the stock price is lower than the book value per share, then either is terrible wrong with the company, or this qualifies the company stock as a bargain (i.e., a potentially excellent investment opportunity). On the other hand, a huge disparity between them would indicate an unfounded overvaluation of the company, unless very high EPS values could justify it. But recall that very fast growth rates suggest extra caution, since this situation is seldom sustainable at the long-term.
Net profit over sales ratio Edit
Valuing a stock Edit
A number of models exist for valuing stocks, and part of the process includes determining which model is most appropriate for the security in question.
Price/Earnings Ratio (PER) Edit
This ratio compares the price of a stock with the EPS of the company behind it. In other words, it assesses how many times the stock price is higher than the company earning power. Since this ratio does not depend on the company size, nor any other absolute quantities, it can easily be compared across companies, and even across different activity sectors.