Analyzing stocks is considered both a skill and an art since different evaluation methods have sometimes made investors look foolish. Some investors look at the financial data under the hood of a particular publicly traded company. Others look for patterns in the short-term gyrations of stock prices. And then you have buy-and-hold investors who simply buy index funds and never even look at company or stock price data.
In this article, we'll explain what fundamental analysis is and how it helps investors make informed decisions.
What Is Fundamental Analysis?
Fundamental analysis evaluates a stock's intrinsic value by reviewing financial statements, economic factors, and company specifics like management and industry conditions. It helps investors identify undervalued or overvalued stocks and assess long-term growth potential.
By analyzing financial data, fundamental investors look for opportunities to buy undervalued stocks or spot warning signs of overvaluation or internal problems. The analysis typically involves reviewing income statements, balance sheets, and earnings calls.
A common metric is the price-to-earnings (P/E) ratio, which compares a stock's price to its earnings per share (EPS), helping investors gauge stock value and performance.
How Fundamental Analysis Differs from Technical Analysis
Fundamental investors focus on owning shares in companies for the long term. They care about the company’s performance. On the other hand, technical investors — usually short-term traders — focus on price movements and patterns. They don't care much about the company’s financials, just the price direction.
Technical traders use tools like moving averages, volume, and stock charts to find price patterns. They also pay attention to "support" (where stock prices tend to stop falling) and "resistance" (where prices tend to stop rising). These traders typically ignore company fundamentals and focus on short-term price movements.
Some investors use both fundamental and technical analysis. They may choose stocks for long-term investment using fundamental analysis and trade more frequently using technical analysis.
Key Components of Fundamental Analysis
So, what should you look for when performing fundamental analysis? Not every investor trusts the same metrics or digs as deeply into statements or conference calls. However, all investors researching fundamental analysis stocks should familiarize themselves with the following components:
Financial Statements
Financial statements include three documents, easily located through MarketBeat's analysis tools.
- Income Statement: The income statement is distributed quarterly with earnings and shows the company's revenue, expenses and profits.
- Balance Sheet: A company lists its assets and liabilities on the balance sheets. Fundamental investors will avoid companies with too much debt or liability.
- Cash Flow Statement: This is where you will find capital expenditures, debt issuance and repayment, and stock buybacks. Companies with cash flow problems may have trouble meeting future obligations, which is a warning sign for investors using fundamental analysis.
Economic Indicators
Individual company performance isn’t the only thing directing stock prices. Economic data can hint at future business profits in specific sectors and industries. For example, inflation has been one of the hottest economic data points since the end of 2021. Inflation measures a few different metrics, most notably the personal consumption expenditure (PCE) and Consumer Price Index (CPI). Companies that can maintain pricing power often do well during inflationary periods, and fundamental analysis can provide insight into which companies can maintain their profits.
Industry Analysis
Investors use fundamental analysis of stocks not just to compare industries but also to compare competing companies within the same stock sector. For example, an industry like the consumer staples sector isn’t as concerned with profit growth as the tech sector since consumer staples products often have inelastic demand. Financial data like the cost of goods sold (COGS) will be more crucial in determining the health of stocks in this sector.
If you compare two consumer staples stocks, numbers like COGs or margins can help determine which company is a better buy. If it costs The Proctor and Gamble Co. NYSE: PG more to sell household products than The Colgate-Palmolive Co. NYSE: CL, then fundamental investors may prefer to own CL shares over PG shares on the expectation that more revenue will turn into profit at Colgate-Palmolive.
How to Conduct Fundamental Analysis
Now that you know the goal and tools of fundamental analysis, here's how to start your own analysis.
1. Gather Financial Data
Collect key financial documents like the income statement, balance sheet, and cash flow statement. These documents provide the raw data needed to understand the company's financial performance.
2. Analyze Key Financial Ratios
Use ratios such as price-to-earnings, price-to-book, price-to-sales, and debt-to-equity to evaluate the company's financial health. These ratios offer insight into profitability, valuation, and financial stability.
- Price-to-Earnings (P/E) Ratio: Compares the stock price to the company’s earnings per share (EPS). It indicates how much investors are willing to pay for each dollar of earnings. A high P/E suggests growth expectations, while a low P/E may indicate the stock is undervalued.
- Price-to-Book (P/B) Ratio: Compares the company's market capitalization to its net asset value. It shows how the market values the company relative to its book value.
- Price-to-Sales (P/S) Ratio: Similar to the P/E ratio, but uses revenue instead of profit. It helps evaluate companies with temporary earnings fluctuations.
- Debt-to-Equity (D/E) Ratio: Measures a company's debt relative to its equity. A ratio above 1 means the company has more debt than equity, which can be a risk if too much revenue is spent on debt repayment.
3. Assess Industry and Economic Conditions
Examine how the company fits within its industry and the broader economic environment. This helps determine external factors that may impact the company's performance.
4. Compare to Competitors
Compare the company’s performance and valuation with similar companies in the same sector. This provides context for whether the company is outperforming or lagging behind its peers.
5. Determine Intrinsic Value
Evaluate whether the stock is undervalued or overvalued based on the financial data and ratios. This step helps establish a fair price for the stock relative to its earnings and assets.
6. Make Investment Decision
Decide whether to buy, hold, or sell based on your analysis of the company’s long-term potential and current valuation. Your decision should align with your investment goals and risk tolerance.
Hypothetical Example
Imagine you compare two stocks in the same industry: The Coca-Cola Company NYSE: KO and PepsiCo Inc. NASDAQ: PEP. Most people can’t even tell the difference between Coke and Pepsi, so how do you choose one stock over another? By using fundamental analysis.
In this fictional scenario, imagine KO trades at a P/E of 10 and PEP trades at a P/E of 20. If the average P/E in the consumer discretionary sector is 15, KO is cheaper to own than PEP and well below the industry standard. A deeper dig into the financial statements might show that Pepsi's margins are declining, meaning that the company keeps less of its revenue as profit. You could add KO shares to your portfolio instead of PEP using this information.
Challenges and Limitations of Fundamental Analysis
Fundamental analysis can teach investors about a company's financial health but doesn’t predict the future. A good company doesn’t necessarily mean a high-flying stock; many businesses don’t produce returns.
For example, the COVID-19 pandemic set off a barrage of stock trading activity that retrospectively made little sense. Companies with no earnings saw meteoric stock returns, outperforming successful businesses with growth potential. Fundamental analysis is useful but won’t always produce winners, especially in markets like 2020, where fundamentals flew out the window.
Fundamental Analysis Helps Long-Term Investors
If it were easy to predict stock prices in the long or short term, we wouldn't have a stock market. Even the best fund managers like Peter Lynch or Jim Simons knew the limitations of their strategies and theories.
Fundamental analysis in trading is a tool like any other. It can provide helpful insight into the financial health of a particular company, but it can never truly predict where the stock price will go next. Some businesses that turn steady profits aren't rewarded in the stock market. In contrast, others with poor fundamentals or bad management can defy logic and double up quickly (looking at you, meme stocks). Fundamental investing might be more science than art, but it still doesn’t clarify the future of individual stock prices.
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