Fundamental analysis is popular among stock traders, who pour over all the available data on a company to decide whether to invest.
As with all types of fundamental analysis, examining a company involves researching as much available information as possible to decide whether its shares are underpriced or overpriced.
Company analysis falls into two main areas: looking at the company itself, and the wider factors surrounding it.
The simplest way to take your view on a company is by reviewing the financial figures it discloses to investors in its earnings reports. Any listed company is required to release earnings – often once a quarter, with a more comprehensive statement each year.
Lots of large public companies will release their earnings during the same rough period each quarter – a time known as earnings season. Earnings season can have a significant impact on the overall stock market performance of an economy. If lots of companies ‘miss’ their expected profits and revenues, major indices may fall.
There are a few areas of the earnings report you might want to pay attention to:
1. Income statement
The company income statement is where a firm will report its revenues, costs and net earnings, as well as various calculations of the business’s profit – for three months in a quarterly statement, or 12 in an annual one.
Income statements will often cover lots of different metrics. Most, though, will include the following:
- Revenue. All the money made in the period, without any costs subtracted
- Expenses. Capital spent on earning revenue, including the cost of goods sold (COGS)
- Net income. Total revenue minus total expenditure. Also known as profit or earnings
- Earnings per share. Total profit divided by the number of outstanding shares. Used to measure profitability
- Gross margin. A measure of how efficiently a company is making sales, calculated by dividing net income by revenue
- Interest payments. The payments the company is making on its short and long-term interest
- Gains and losses. Any income or losses that aren’t from sales or expenses – for example by selling some unused equipment
Other important metrics
You’ll see these figures listed on almost any income statement. But there are lots of unique metrics in individual industries that may be important too. Investors in upcoming tech businesses, for example, may be more interested in user growth than revenues.
2. Balance sheet
The company balance sheet gives you a snapshot of everything a firm owns and owes at a particular point in time. You can see when the snapshot was taken by looking at the date at the top of the report.
A balance sheet will include:
- Assets. Everything a company owns, including goods, property and more
- Liabilities. Debts or other claims on a company’s assets
- Shareholder equity. All the claims made by the company’s owners or shareholders
Assets vs liabilities
The balance sheet gets its name because assets and liabilities should balance each other out. In practice, that means the total of the liabilities and shareholder equity is equal to the assets. In this way, the balance sheet tells you how the business is paying for everything it owns.
3. Cash flow
The cash flow statement tells you how a company is generating the money it needs to cover its operating expenses, debts and investments. You can use it to explore whether a business has sound financials, as well as where it is spending its cash.
A cash flow statement will comprise of three components:
- Operating activities. Any sources or uses of cash from the day-to-day operation of a business
- Investing activities. Any money used to invest in the long-term future of the company
- Financing activities. Cash from investors or banks, as well as money paid to shareholders
Fundamental analysts will often use the figures from earnings reports to calculate rates which offer a quick gauge of performance. These may include:
Price to earnings (P/E ratio)
The P/E ratio compares a firm’s current share price to its earnings per share, telling you how much you are paying for each dollar (or pound, euro, etc) of profit. P/E is used to determine how expensive a share is when compared to the money a business is making.
Companies in different sectors will have vastly different P/Es, so it is worth doing your own research to determine what looks like fair value for your chosen sector. And if a company hasn’t yet earned a profit, then P/E won’t tell you anything.
Price to book (P/B ratio)
The P/B ratio, meanwhile, compares a firm’s current share price to its book value per share. To calculate book value per share, you minus any liabilities from the total assets on its balance sheet and divide that by its outstanding stock.
A higher ratio means that the markets value a company above and beyond its tangible assets (such as buildings, machinery and inventory). This may mean investors prize its intangible assets, such as their brand, long-term contracts, patents or customer loyalty.
Return on assets (ROA) and return on equity (ROE)
Like P/E, these two ratios use a stock’s total profit to evaluate performance. But instead of comparing it to the company’s share price, they examine how it is using its assets and its equity.
- ROA indicates whether a company is generating a solid return on its assets
- ROE does the same, but for equity (or assets minus liabilities)
Both ratios are expressed as a percentage, and can offer an insight into how efficient management is at converting assets or equity into profits.
Other things to consider
Outside of an individual earnings report, there are several points you might want to cover when assessing an individual stock. These can include:
- Copyrights or patents. For some companies – such as those in software or biotechnology – copyrights and patents can be immensely valuable
- Performance over time. A year or quarter’s worth of figures won’t show much. You get a much better view by assessing multiple reports across different economic and operating environments
- Expenses vs gross profit growth. If costs start increasing at a faster rate than profits, a company might be having problems controlling its spending
Earnings reports can tell you a lot about a business, but they won’t tell you everything. Before you buy or sell a stock, you’ll need to take a look at some other data sources too.
The number of areas you can investigate is practically limitless. But many investors simplify things by taking a top-down approach.
1. Start with the wider economy
A growing economy is a huge benefit to businesses, so most investors will want to focus on countries that are performing well – and avoid those in a recession.
2. Look at specific sectors
Now, you can take a look at how a sector might perform overall in the coming months and years. Could central bank actions or new regulations harm this industry? Or do you think consumer demand is set to grow?
3. Compare the company to its peers
After analysing the sector overall, you should be able to get an idea of which companies are the big players, and which might be outperforming the average. Using the ratios covered above can be particularly useful here, enabling you to see how each stock is performing against its competitors.
Test your knowledge
- A 35
- B 25
- C 40
- A 24
- B 30
- C 26
- A 19%
- B 50%
- C 34%