What is Fundamental Analysis?
If you’re trying to decide whether to invest in a particular stock, you have to take more than just the price of the stock into account. What will drive its success? Is it likely to make profits that keep pace with the cost of your investment? Fundamental analysis can help you answer these questions by predicting which stocks are most likely to succeed and thrive, and then putting your money where it can do the most good. Read on to learn more about fundamental analysis and how it can help you make good investment decisions.
The Basics of Fundamental Analysis
What Is It, Really? Before we go into how fundamental analysis works, let’s define what it actually is. Fundamental analysis provides insight into a company’s potential growth based on financial factors such as price-to-earnings ratios and historical profit growth rates. In other words, you analyze past performance in order to predict future performance—and then choose investments accordingly.
Indicators in Fundamental Analysis
To use Fundamental analysis, you'll need to understand a few important financial metrics. The most common ones are EPS (earnings per share), P/E (price-to-earnings ratio), ROE (return on equity), and EBITDA (earnings before interest, taxes, depreciation, and amortization). Let us understand these indicators in detail.
EPS (earnings per share)
One of a number of key financial measures used to determine how profitable a company has been in its most recent quarter or year. EPS stands for earnings per share, which represents a company's net profit divided by its outstanding shares. Most professional investors look at these key numbers as they can give them an indication as to whether or not stock may be overpriced. By comparing earnings to price, some investors attempt to assess whether or not stocks are fairly valued. As a general rule, if a stock has high earnings with low share prices, it may be due to an increase in price. And vice versa; if you find low earnings with high share prices, you may see lower valuations in that stock.
P/E (price-to-earnings ratio)
This compares stock prices to company earnings. It’s one of the most basic ratios that investors use to value a company. It looks at how much investors are willing to pay for each dollar of earnings. For example, if you were looking at two stocks, one that had a P/E ratio of 10 (meaning investors were paying $10 for every $1 in earnings) and another with a P/E ratio of 5 ($5 per $1 in earnings), you would be able to quickly tell which stock was cheaper—but they would also have different long-term investment potentials. You can figure out P/E by dividing the current stock price by the latest 12 months' EPS figures.
ROE (return on equity)
This ratio measures how effectively a company uses its total capital to generate profit. A high ROE shows that a company is able to earn money for its shareholders. A low ROE indicates that you’re not getting much bang for your buck. This ratio can tell us whether a firm has been using all of its available capital efficiently—or if it could be doing better. A lower number than usual may indicate that the business isn't operating at full capacity, or its strategy doesn't work as well as other firms in the same industry. But sometimes, a low ROE can indicate that there are other issues going on, such as bad investments or poor management decisions. Generally speaking, an ROE under 5% is considered unhealthy for any company because it means that the majority of the company's profits are used to cover its debt service obligations rather than to pay out dividends or reinvest in the business. If we see this number change significantly over time, then this might be a sign of trouble ahead.
EBITDA (earnings before interest, taxes, depreciation, and amortization)
The earnings of a company before accounting for interest, taxes, depreciation, or amortization are known as EBITDA. This earnings number can be useful in assessing a company’s current financial health. However, EBITDA should not be used as an alternative to net income on your financial statement because it omits important information about a company’s performance like how much money was made from selling inventory.
Fundamental Analysis versus Technical Analysis
Some investors like to take a technical, or quantitative approach to investment. They look at charts of a stock’s price history and trading patterns in order to predict where they think prices will go next. Some like to take a fundamental, or qualitative approach; these investors focus more on an underlying company’s financial health—its income statement, balance sheet, etc.—and use that information to determine whether they want to invest in that company. What's important about this distinction is that one type of analysis isn't better than the other. It's just different ways to analyze the same thing: stocks.
It can take a while to get used to trading with fundamental analysis, but many investors agree that once you’ve learned how to use it correctly, there’s no better strategy for understanding where stocks are headed.