Stock Trading: How to Use Fundamental Analysis
There are different methods for understanding stock trends to determine value and whether you should buy or sell. With fundamental analysis (FA), traders look at the stock’s intrinsic value by evaluating related financial and economic factors. Then, analysts check other factors that may change the stock’s value. For example, they may look at macroeconomic elements such as industry conditions or microeconomic factors like how well the company’s sales looked year-over-year.
The result is that the trader knows whether the stock’s current price is higher or lower than what the stock’s fair market value is. Basically, is the stock undervalued or overvalued?
Fundamental analysis can also lead to understanding market expectations and finding new stocks worth investing in.
Most investors love buying undervalued stocks because it means that the stock price will likely increase fast, leading to higher profits.
Fundamental analysis is not used by short-term traders or active traders for the most part. Those investors like to use technical analysis, which predicts the direction of a stock’s price through historical market data like volume and price.
Quick Tips for Fundamental Analysis
- You can use fundamental analysis to understand a stock’s real fair market value.
- If you use fundamental analysis, then you’ll look at stocks trading at higher or lower prices than their actual fair market value.
- If a fair market value is forecasted as higher than its market price, then the stock is undervalued. Investors would typically jump to purchase an undervalued stock.
- Technical analysis ignores fundamentals focusing on historical trends of the stock instead.
Why Use Fundamental Analysis
Understanding fundamental analysis is necessary to determine whether a stock is valued correctly in the market. Analysts typically look at macro and micro factors to identify stocks that are trading at higher and lower prices. If a stock isn’t priced correctly, it could be worth more money and turn a higher profit. This is especially true when a stock is undervalued.
Analysts look at the big picture and drill down into small details when it comes to fundamental analysis. They like to evaluate the state of the economy as a whole and then look at the specific industry in relation to the stock. Then, they look at micro factors such as the company’s sales performance. Through this research, an analyst can see what the fair market value is for a certain stock.
One example is an analyst who looks at a bond’s value by studying economic factors like interest rates and the performance of the bond issuer, such as historical changes in credit rating.
Fundamental analysis of stocks uses earnings, future growth, revenues, return on equity, profit margins, and a variety of other data sets to see a company’s performance and value. This mainly involves look at a company’s financial statements over a period of months or years.
Most analysts use fundamentals to evaluate securities. If you start out looking at the broader picture of the economy and industry, then look into the company’s financials, you are conducting a fundamentals analysis rather than a technical analysis.
How to Invest with Fundamental Analysis
If the stock’s intrinsic or fair market value is higher than the current price on the market, then the stock is said to be “undervalued.” This means you should buy the stock as fundamental analysis indicates the price is likely to go up. However, if the fair market value is lower than the price on the market, then it is “overvalued.” In this case, investors should sell the stock if the analysis predicts a down trend.
Investors who are in it for the long-term rewards typically use a fundamental analysis because it’s expected that the stock price will go up when a stock is undervalued. In this case, they’ll “go long” with undervalued stocks. However, they’ll “go short” with stocks that are expected to drop in value. These are typically stocks that are currently overvalued.
Quantitative vs Qualitative Fundamental Analysis
When determining what fundamentals to analyze, many factors come into play. It can mean anything related to the economic conditions surrounding a company. Typically, analysts always look at numbers like revenue, losses, and profits over a period of months and years. They also look at the company’s current market share to the quality of how the company is run.
These fundamentals break down into two categories: quantitative analysis or qualitative analysis.
- Quantitative Fundamental Analysis: This means that the data can be measured and stated in a numerical way. You can look at the number of sales, production costs, and revenue.
- Qualitative Fundamental Analysis: This data relates to the quality or character of something, such as how well a company is managed or whether a company has poor customer satisfaction ratings.
Quantitative analysis basically crunches data down into hard numbers. You can see how many units of a product were sold in a quarter. You can tell if a company made higher profits last year versus the year before. This is why fundamental analysts look at financial statements.
Qualitative fundamentals are not exactly tangible or hard like the numbers. This data is made up of impressions typically. For example, how are the company’s key executives doing on social media? Does the brand have a lot of market share? What’s the quality of their patents or were any product lines recalled? This information is combined with quantitative data to get an overall understanding of the stock’s fair market value.
Even if a company’s financial statements look good, there may be a recent news story or reports of bad products by customers leading to poor satisfaction.
Qualitative Factors for Stock Analysis
- Business model: What does the company do, and is it sustainable? How are they planning to expand? Do they mainly rely on royalty and franchise fees? You should see how well a company is making money through multiple methods.
- Competitive Analysis: How is the company stacking up against competitors? You typically want to invest in companies that have some kind of competitive advantage. For example, Coca Cola is a worldwide recognized brand name. Microsoft has a dominating hold over the personal computer space and business to business sector.
- Company Leadership: How well is the company managed? Do you trust their executive team? The best businesses may fail if they don’t have good managers or board members. You may look at previous experience or whether they have been unloading stocks rapidly.
- Corporate Governance: Is the company run fairly? Do you think that it respects shareholder’s rights and interests? Corporate governance is defined by policies set in place by the company that defines relationships and responsibilities. You should always pick companies that are run ethically, efficiently, and transparently. If you don’t understand their communications to shareholders, then you probably were not meant to.
Quantitative Factors for Stock Analysis
- Company financial statements, such as income statements, balance sheets, cash flow statements
- The balance sheet shows you a record of the company’s liabilities, equity, and assets
- Assets equals liabilities plus shareholders investments compared against the company’s total value or equity.
- The income statement measures revenue, expenses, and profits within a certain period of time
- Cash flow statements show incoming and outgoing cash. For example, there is cash from investing or CFI, which is used for investing in assets like equipment. It also relates to profits from selling other business or company equipment. There is also cash from financing or CFF, which relates to cash paid or received from the start of borrowing or issuing funds.
- Operating cash flow or OCF relates to cash generated on a daily basis from your business operations.
The cash flow statement is considered to be the most important factor. Businesses cannot hide cash situations very easily. While accountants may be able to play with the numbers on earnings, they cannot fudge the numbers on a bank account statement. Conservative investors rely on cash flow statements to get a basic understanding of a company’s performance.
The Concept of Fair Market Value or Intrinsic Value
The underlying assumption of fundamental analysis is that the price on the market does not reflect the stock’s actual value. This is called an intrinsic value.
If a stock is trading at $20, but after some extensive fundamental analysis, you find that the company is actually worth more. Then you may say the company’s stock price has an intrinsic value of $25. This is a good tip for an investor who wants a long-term stock that will go up in value.
You want to purchase stocks that are trading lower than their intrinsic value.
The other basic concept of fundamental analysis is that a stock’s value is more aligned with long-term investment interests. One main criticism of this is that people do not know how long a stock will trade for. It could be weeks, years, or decades depending on the company’s success.
Critics of Fundamental Analysis Say
Most criticisms of fundamental analysis come from technical analysts. These analysts look at stock trends from another point of view. They use the historical price and volume of a stock over a period of years to determine how well it is likely to perform. They trade on the momentum of a stock rather than its fundamentals.
One of the main components to technical analysis is that the market always discounts everything. All news about a company is typically already incorporated into the price as the stock is being traded currently. The stock’s price jumps and lows give better insight into the underlying success or problems of a company.
There is also the efficient market hypothesis, which sharply contrasts both fundamental and technical analysis. These analysts like to say that it is impossible to beat the market through either method. Instead, the market is always efficiently pricing the stocks second-by-second, and any opportunities for higher returns are whittled away by the way the market is currently flooded with investors. The main point is that no one can beat the market price in the long-term.
Popular Tools of Fundamental Analysts
If you want to understand how the market values a stock and whether you should ultimately buy, sell, or ignore, then you can use several tools to understand a company’s profile.
Most of all, you want to look at the earnings and cash flow statements. Basically, how much money is the company making and what is it likely to make in the future?
When a company doesn’t earn enough in a quarter, the business often suffers a lower stock price. Fundamental analysis is one way to to project a company’s future earnings.
While earnings tell you a lot about a company, you need to look at earnings, growth, market value, and other factors. These are some of the tools that professional analysts use to look at a company’s fundamentals:
- Earnings per Share or EPS: You can get this number by calculating the net income fewer dividends on a preferred stock divided by the amount of outstanding shares. Basically, how much of a company’s profit is assigned to each stock share?
- Price to Earnings Ratio or P/E: This is a ratio that looks at the current sales price of a company as a whole and then compares it to the per-share earnings.
- Projected Earnings Growth or PEG: This projects the one-year earnings and growth rate of a company’s stock price.
- Price to Sales Ratio or P/S: This is the value of a company’s stock price compared to its revenue numbers. This is also referred to as a PSR, sales multiple, or revenue multiple.
- Price to Book Ratio or P/B: This ratio defines the price to equity and compares the stock’s “book” value to its market price. Analysts get this number by dividing the stock’s latest closing price by the last quarter’s book value per share. Book value is defined as the value of an asset as it appears on the company’s financial sheets. It is equal to the cost of each individual asset minus cumulative depreciation.
- Dividend Yield: This is another ratio that compares the yearly dividend to a share price. It is always expressed as a percentage. To get this percentage, you would divide the dividends paid in a single year period per share by the total value of a share.
- Dividend Payout Ratio: Analysts look at the dividends that were paid out to stockholders and compare the number to the company’s total net income. This accounts for retained earnings and income that has not been paid out. Instead, that income has been retained for future growth.
- Return on Equity: You can get this number by dividing the company’s net income by the shareholder’s equity. This gives you the total return on equity. This is also noted as a company’s return on net worth.
While some of these are old school tools, investors like to look at earnings per share to see what makes a stock cheap or expensive in the eye of a trader. Once you know that, you can predict whether a stock will perform better or worse in the next few years.
Final Word: Evaluating Stocks with Fundamental Analysis
Fundamental analysis offers insights into a company’s well-being as well as historical performance ratios to predict the future growth and success of a stock. As you build a portfolio, you want to have stocks that are projected to increase your returns in the long-term. Fundamental analysts often predict future outcomes and may earn you more money by focusing on undervalued stocks.