To invest in stocks, fundamental analysis is one of the two methods of analysing financial assets. It involves conduction analysis on the factors that affect the intrinsec value of the assets.
Just to make an example, in currencies, interest rates, manufacturing production, and inflation help determine the direction the asset will move to.
In commodities like crude oil, data on supply and demand help investors predict the direction of the asset. In companies, these economic data are also important. However, there are other details to consider when making decisions about the stocks of companies you want to invest in.
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.
Fundamental data you should always check
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 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.
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 team.
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 are adding. As insiders, there probably know things that you don’t know.
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.
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).
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.
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.
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 in the internet.
You can also get this information from the 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