Fundamental analysis is an approach to investing that utilizes a variety of qualitative and quantitative metrics to determine what the intrinsic value of a company is. The goal of fundamental analysis is to forecast the true, imputed value of a company, based solely off of reported and available financial data, to ultimately profit off of the future price movement. Fundamental analysis is typically used by longer term investors, and technical analysis, a different approach that also relies on financial data, is typically used by day traders.
Fundamental analysis, also known as quantitative analysis for its heavy reliance on hard numerical data, involves analyzing a company’s financial statements. Such analysis centers on looking at revenue, expenses, assets, liabilities and other financial metrics. Fundamental analysts look at this information to gain insight into a company’s future performance, which directly drives the price of a stock.
Assumptions of Fundamental Analysis
The foundation of fundamental analysis is built off of the theory that the stock market is not always a rational market. This creates an opportunity for an investor to capitalize on opportunities, but only when they know what to look for. There are two primary assumptions associated with fundamental analysis.
1) The current stock price does not fully reflect a stock’s intrinsic value
2) In the long run, the stock price will ultimately reflect the company’s fundamentals
What is “Intrinsic” Value?
The “true” value of an asset, based on forecasted profits into the future, is its intrinsic value. If the stock market is an irrational marketplace, the market value may not match the true value, which creates an investment opportunity.
Earnings are the profits generated by a company. When a company’s earnings are increasing, the stock price will generally increase to reflect their improved earnings. However, when a company’s earnings are decreasing, the market will react negatively and the stock price will decrease.
What are the Most Popular Fundamental Metrics?
1. Earnings per Share (EPS) – Three types of EPS numbers:
- Trailing EPS – last year’s numbers, it represents the company’s actual earnings
- Current EPS – this year’s numbers, which are projections
- Forward EPS – future numbers, which are projections
2. Price to Earnings Ratio – P/E
- There is no right P/E ratio because part of it depends on what you’re willing to pay. The more you are willing to pay, the higher the P/E is.
- The P/E ratio is the most popular way to compare the relative value of companies.
3. Projected Earnings Growth – PEG
- You calculate the PEG ratio by dividing the P/E ratio by the projected earnings growth.
- A few important things to remember about PEG:
- The PEG ratio focuses on year-to-year earnings growth and it relies on projections, which may not always be accurate.
4. Price to Sales – P/S
- The P/S ratio reflects the value placed on sales by the market. The lower the P/S, the better the value.
- It is NOT recommended to use the P/S metric in isolation.
5. Price to Book – P/B
- You calculate P/B by dividing current share price by the book value per share.
- The lower the P/B, the better the value.
6. Dividend Yield
- For income investors, this is one of the most important metrics. It tells you what a company pays its shareholders in the form of dividends. Mature companies tend to have a higher dividend yield than younger companies.
- Dividend yield is calculated by dividing the annual dividend per share by the stock price.
7. Book Value
- The Book Value is simply the company’s assets minus its liabilities.
- Book Value = Assets – Liabilities
- A company that has a viable business model will always be worth more than its book value.
8. Return on Equity
- Return on Equity (ROE) measures how efficiently a company uses its assets to produce earnings.
- ROE is calculated by dividing Net Income by Book Value.
None of these metrics in isolation will give you a buy or sell recommendation. Many different quantitative factors are weighed when deciding which stocks represent a purchase opportunity and which should be avoided or sold. At Technical420, we handle that for you and allow you to make the most informed decision possible.