Fundamental analysis is one of the two main ways in which traders and investors use to identify opportunities in the market. It involves looking at the key issues that affect financial assets like stocks, cryptocurrencies, and commodities.
Fundamental analysis is used by both long-term investors, swing traders and day traders. In most cases, however, it is not mostly useful for day traders since they mostly focus on technical analysis.
In this article, we will look at some of the key things to look at when conducting fundamental analysis in stocks.
See also how to use Supply Chain Analysis in Stocks Investing
Contents
What is fundamental analysis?
Fundamental analysis is a method mostly used by investors and traders to assess the price movement and fair value of an asset. For example, if you are given a company’s income statement, balance sheet and cash flow statement, you can find its fair value easily.
Similarly, if the Fed decides to raise interest rates, you can assess the potential movement of specific stocks or currencies.
Best sources of company fundamentals
A common question is on the best sources of fundamental data about companies in the market. Most fundamental data can be found in a company’s financial statements, which are published every quarter. The statement includes the income statement, balance sheet, and cash flow statement.
However, most investors use many platforms that simplify all these numbers. Some of the most popular sources of fundamental analysis data are SeekingAlpha, Investing.com, Barchart, WeBull, and Bloomberg.
Most online brokers like Robinhood, Schwab, and WeBull provide popular fundamental information like news, financial calendar, and data.
Qualitative vs Quantitative in fundamental analysis
There is a lot of fundamental data that you can use in the financial market. These numbers are divided into two: quantitative and qualitative fundamentals.
Quantitative fundamentals refer to metrics that are expressed in numbers. Some of the most popular quantitative numbers are:
- Price-to-earnings (PE)
- Price-to-sales (PS)
- EV to EBITDA
They also include financial results metrics like income statements, balance sheet, and cash flows.
Qualitative metrics, on the other hand, refers to any fundamental thing that cannot be measured in numbers. They include a company’s news, competition, management changes, and macro and geopolitical events.
Fundamental data you should always check
Valuation multiples
One of the most common fundamental aspects that many investors look at when valuing stocks is multiples. It is a simple process where you look at a company’s financial multiple and then assess whether it is fairly valued or undervalued.
In an ideal situation, companies in the same sectors should have similar valuation multiples (this is known as correlation). For example, ExxonMobil and Chevron or Pioneer Natural Resources and Devon should have similar multiples.
While valuation multiples are important, they are mostly not used by day traders. Instead, they are used by long-term investors who are mostly interested in a company’s valuation. Traders are only interested in how the stock is moving in a chart.
Some of these multiples are:
- Price-to-earnings (PE) ratio – This is a ratio that measures the current stock price to its earnings-per-share. A higher ratio means that the stock is highly valued.
- Price-to-sales (PS) ratio – This one measures its stock price in relation to its sales.
- EV to EBITDA – This ratio measures the company’s enterprise value in relation to its EBITDA.
- Debt to equity – It measures the state of the firm by comparing its total debt and its equity value. Ideally, investors want to invest in stock companies that have little debt in relation to their equity.
Dividends
Dividends are the sums of money that a company distributes to shareholders. In most cases, these dividend payouts come straight from a company’s profits.
In other cases of financial engineering, companies tend to take loans to pay dividends. At times, especially when interest rates are low, it can make sense to borrow to pay payouts.
While dividends are important to investors, traders don’t focus on them. They only react to dividend news such as when a company decides to cut or add dividend.
Management Team
Companies that do well are those that have excellent management team. A good way to look at this is to look at the company’s annual report for details about the board of directors and the executive teams.
Look at their previous experience, their compensation, and their independence. In addition, look at their stake in the company and whether they are buying or selling their stake.
Ideally, you should invest in stocks from a company whose management has a large stake or one who is adding. As insiders, they probably know things that you don’t know.
Industry
If you are investing in a company for the long term, you want to invest in an industry that is growing.
For example, at a time when the newspaper industry is dying, it does not make sense to invest in newspaper companies. Other industries that are seeing slowdown in growth are taxi and car hire services, mall retailers, bookstores, and cameras.
Instead, you should focus on industries that are seeing growth like e-commerce, fintech companies, and electric vehicles.
In this case, investors also focus on competitors. For example, during the earnings season, companies in the same industry tend to move in the same direction.
Let’s explain this: banks like Goldman Sachs tend to rise when companies like Wells Fargo, JP Morgan, and Citi publish encouraging results and vice versa.
Also, they watch the performance of competitors and whether they are gaining market share. In most periods, companies that are growing their market share will do better and vice versa. Some of the top tools to conduct competitor analysis are SimilarWeb and Google Trends.
Balance Sheet
The balance sheet of a company documents the assets and liabilities. Ideally, you should invest in stocks from a company that has growing assets and one whose liabilities are shrinking. This is because a company that does not have a good balance sheet is usually exposed to bankruptcies.
For example, Sears, which was once the biggest retailer filed for bankruptcy after its debt reached tens of billions of dollars. Instead, you should invest in companies like Facebook that have billions of dollars in cash and little debt (or some other blue chip stocks).
Cash Returns
As a shareholder, you will make money through share appreciation and dividends. Therefore, the company you invest in should treat their shareholders well by returning money to them through dividends and share repurchases.
You should ensure that the payout ratio is adequate because this will ensure that the company is in a good financial position.
Valuation
A good company at a stretched valuation is not a good investment. Instead, you should aim to invest in stocks of good companies at a relatively low valuation. There are a number of ways to look at the valuation of a company.
One of the most common methods is to look at the price to earnings ratios and the price to sales ratios, as stated above. As you advance, you should look at other approaches like the discounted cash flow method.
Profitability metrics
Another fundamental information to consider are profitability metrics. These are numbers that show how a company’s profitability is.
They include metrics like margins (gross, operating, EBITDA, and net), return on equity (ROE), return on invested capital (ROIC), and return on assets (ROA).
Soft Information
There are a number of other soft information that you can use to evaluate the success of a company. For example, you can read the user reviews of its products. You can find these reviews on the internet.
You can also get this information from social media networks. Further, you can look at the reviews of the management. The best place to look at this information is in Glassdoor. You can also look at the company’s hiring page to see the trend that it is following.
External useful resources
- Analyzing stock fundamentals – Fidelity