Knowledge is power, especially when choosing which stocks to invest in or sell to build a strong portfolio.
One method that might help you figure out the intrinsic value of a stock is fundamental analysis. When you think you know the fair market value of a stock, it can help you determine whether it’s a suitable stock to buy and when to buy or sell it.
Even if you’re working with investment advisors to build your portfolio, knowing the process of how to read the fundamentals of a stock can help you be a smarter investor.
What Is a Fundamental Analysis?
Generally the method is used more by professional analysts than by individual investors, but individuals can use it as well, since much of the data used is public.
Through this process, an investor aims to discover the true value of the asset and use that information to decide whether its current market price makes it a fair buy or sell. The goal is to find a stock that is currently undervalued and may grow in value over time, or to sell one that is currently overvalued.
There are a couple of other common stock analysis methods that you may hear about. One is called technical analysis—it is often contrasted with fundamental analysis. Technical analysis is more commonly used for short-term trades. It focuses on charting a stock’s price movement and volume to analyze patterns and make forecasts.
A third type of analysis is called quantitative analysis. This is used to look at the historical performance of a stock. Quantitative analysis looks at metrics such as earnings per share and discounted cash flow (DCF). This method is generally used in conjunction with fundamental analysis and technical analysis, not on its own.
Although fundamental analysis is generally used for long-term trades and technical analysis for short-term trades, it might be helpful to look at both when making investment decisions. Each one reveals different types of information, which might all be used to create a more complete picture of the value of a stock.
How Does Fundamental Analysis Work?
Typically, the first step in using fundamental analysis is to evaluate macroeconomic factors such as the current state of the economy and the industry of the stock. Next, an investor looks at the company itself, by evaluating revenues, earnings, growth potential, profit margins, competitors, management, and more.
The factors an investor might take into consideration during the process of using fundamental analysis are:
• Is the company making a profit?
• Is the company showing growth?
• What is the company’s past revenue?
• Is the company taking on more debt or paying off their debts?
• What are the company’s employee turnover rates?
• Are the company’s employees being taken care of?
Some of the metrics that might be used during fundamental analysis include the price-to-earnings ratio (P/E), earnings per share (EPS), and cash flow. These metrics help analysts look at the difference between different companies and their stocks.
When looking at the price-to-earnings (P/E) ratio in fundamental analysis, the goal is to find a company that has a much lower ratio compared to similar companies. In order to find a company’s P/E ratio, divide the stock’s current price by its earnings per share.
The ratio can be used to compare companies within the same industry or similar types of investments. A high P/E ratio may reflect over-valued stocks, or investor expectations of a growth later on. A lower P/E, on the other hand, may imply lower earnings per stock. And if a company has no earnings, if it breaks even or has losses, the P/E ratio will not work.
Earnings per Share
Earnings per share (EPS) is another metric used for stock valuation when using the fundamental analysis method. The EPS is found by dividing the company’s net income by the weighted average of the common shares outstanding.
If EPS is being used to make predictions about the future rather than evaluating the current value of a stock, you would need to use the expected future outstanding shares.
Another factor taken into consideration when using fundamental analysis is cash flow. This is important because without sufficient cash flow, a company can’t pay out dividends, make new hires, or expand their product and service offerings.
If a company is taking on more debt and isn’t making enough income to pay off previous debts, this may be a warning sign.
Cash flow is generally calculated by looking at the company’s net income plus depreciation plus other assets owned by the company.
How Fundamental Analysis can Help Investors
When you buy something, you want to know that you’re not overpaying. In the same vein, analysts and investors can use fundamental analysis to help figure out whether a stock’s price is fair and attempt to maximize the profits of their portfolios.
Analysts typically give investors information about stocks to help them decide what to buy, sell, or keep. Fundamental analysis can help investors find stocks that are undervalued (to buy), and overvalued (to sell, if they own them).
Fundamental analysis is most useful for longer-term investors, but it can also be used for short-term investments.
Fundamental Analysis Challenges
The main goal of using fundamental analysis is to find stocks that are currently priced less than they are worth. One potential downside of buying these stocks is that other investors may never recognize the value of the stock, or something else may happen which results in the stock never going up in value.
This is partly why fundamental analysis is more frequently used for longer-term holds, as it can take time to see the desired results—if you see them at all.
One way to attempt to avoid this problem is to use fundamental analysis to find strong companies, rather than focusing on finding undervalued stocks. If a company is well positioned in its industry and is showing signs of future growth, it might be more likely to grow and be successful over time.
It may also be beneficial to use a combination of the three stock analysis methods mentioned above—fundamental, technical, and quantitative—when choosing which stocks to buy and when to sell.
Starting Your Own Analysis
If you’re just getting started as an investor, it can be challenging to know which stocks to buy and when to buy them. That’s why tools such as fundamental and technical analysis are so valuable to learn.
You can begin to use fundamental analysis by first deciding what types of stocks you’re interested in buying and what your goals are. Perhaps there’s a certain industry that interests you, or you may prefer more established companies to newer ones.
Once you have your goals in mind, you can begin to narrow down the list of stocks which may fit your criteria. Then, you might use the fundamental analysis methods and metrics to figure out which stocks are the best purchases for you.
Original source: Mediafeed.org