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Stock analysis fundamentals
Feeling overwhelmed by the complexities of deciding which stocks to invest in? Let's unearth what underlies how to decide with fundamental analysis.
It’s a straightforward approach that provides deeper understanding and confidence, paving the way for smarter investing.
This is not about telling you which stocks to pick. Instead, it's about equipping you with the knowledge to conduct your own analysis and understand the language used in the financial markets.
It’s a straightforward approach that provides deeper understanding and confidence, paving the way for smarter investing.
This is not about telling you which stocks to pick. Instead, it's about equipping you with the knowledge to conduct your own analysis and understand the language used in the financial markets.
QUOTE
"The four most dangerous words in investing are: 'this time it's different.'"
Big ideas
- Financial statements are the cornerstone of fundamental analysis, revealing a wealth of information about a company's financial health. For instance, the cash flow statement can offer insights into a company's liquidity.
- The Price-to-Earnings (P/E) ratio, a commonly cited metric, doesn't just reflect current stock prices relative to earnings; it can also indicate investor expectations about future growth, making it a multifaceted tool for you to evaluate a stock's potential.
- Quantitative analysis in fundamental analysis relies on numerical data like financial ratios, while qualitative analysis assesses intangible factors such as management quality and brand strength.
Your introduction to fundamental analysis for stocks
What is fundamental analysis, you might be wondering?
DEFINITION
Fundamental analysis involves delving into the basic, or 'fundamental', financial elements of a company to assess its intrinsic value.
This approach is not about following market trends or listening to hot tips; it's about getting to the very heart of what makes a company tick - its financial health, its management quality, and its position within the wider industry.
Again, it's not about making quick wins, but rather about understanding the underlying value of stocks. From dissecting financials to interpreting market summaries, we'll guide you through the essential aspects that a fundamentalist would consider in their analysis., namely:
Again, it's not about making quick wins, but rather about understanding the underlying value of stocks. From dissecting financials to interpreting market summaries, we'll guide you through the essential aspects that a fundamentalist would consider in their analysis., namely:
- Financial statements (income statement, balance sheet, cash flow statement)
- Company earnings and revenue
- Dividend history and related policies
- Management quality and corporate governance
- Industry and market trends
- Earnings and revenue analysis
Decoding financial statements: The backbone of fundamental analysis
These documents are like a health report for businesses to help you make a diagnosis of their financial state.
In the UK, as in many other countries, the primary financial statements are the income statement, balance sheet, and cash flow statement. All three are neatly summarised for any stock in the Trading 212 app, see the examples below for shares of Apple (AAPL).
In the UK, as in many other countries, the primary financial statements are the income statement, balance sheet, and cash flow statement. All three are neatly summarised for any stock in the Trading 212 app, see the examples below for shares of Apple (AAPL).
Getting to know the income statement
The income statement, also known as the profit and loss statement, is how you understand what a company's profitability is over a specified period. It details revenues and expenses, which add up to give you a net income figure. This statement is a starting point to gauge a company's earnings and spending patterns.
Source: Trading 212 appThe Balance sheet: A snapshot of financial position
Another vital component is the balance sheet, which provides a snapshot of a company's financial position at a specific point in time. It lists three main items - assets, liabilities, and shareholders' equity. The balance sheet is crucial in analysing how effectively a company manages its resources and debts. For example, a strong balance sheet typically shows a healthy ratio of assets to liabilities, indicating financial stability.
Cash flow statement: Understanding liquidity
The cash flow statement, often overlooked, is essential in understanding how a company manages its cash, particularly in terms of operating, investing, and financing activities. This statement offers a clearer picture of a company's liquidity and cash health beyond what the income statement and balance sheet can reveal.
The art of reading financial statements
Reading these can initially seem daunting, but they are just telling a story about a company's financial history.
Careful analysis of these statements over time can reveal trends in earnings growth or debt accumulation. In the context of fundamental analysis, these trends are significant because they are the most concrete guidepost we have to not just past performance but to future potential.
Financial statements can offer qualitative insights too, like changes in accounting policies or unusual transactions can signal shifts in management strategy or highlight potential red flags.
To learn more, check out our guide on How to read financial statements.
Careful analysis of these statements over time can reveal trends in earnings growth or debt accumulation. In the context of fundamental analysis, these trends are significant because they are the most concrete guidepost we have to not just past performance but to future potential.
Financial statements can offer qualitative insights too, like changes in accounting policies or unusual transactions can signal shifts in management strategy or highlight potential red flags.
To learn more, check out our guide on How to read financial statements.
Evaluating company health with earnings, revenue, and dividends
The next step in fundamental analysis is to assess a company's earnings, revenue, and history of dividend payouts. With these, you can evaluate the overall health and future prospects of a company.
Company earnings and revenue: Indicators of growth
Earnings, or net income, reflect the profitability of a company after all expenses and taxes have been deducted from total revenue. Consistently strong earnings can be a sign of a company's robust operational performance.
Revenues represent the total income before expenses and provide insight into the market demand for a company's products or services. A steady increase in revenue is often a positive sign, indicating potential for future growth.
Revenues represent the total income before expenses and provide insight into the market demand for a company's products or services. A steady increase in revenue is often a positive sign, indicating potential for future growth.
Understanding dividend history and policies
A company's dividend history and policies can offer insights into its financial stability and management's confidence in future earnings.
A consistent and possibly growing dividend payout can be a sign of a company's financial health and its commitment to returning value to shareholders. However, this isn’t always the case. Read our comprehensive guide to learn more details on how dividends work.
A consistent and possibly growing dividend payout can be a sign of a company's financial health and its commitment to returning value to shareholders. However, this isn’t always the case. Read our comprehensive guide to learn more details on how dividends work.
Management and standards of corporate governance
The effectiveness of a company's management and the quality of its corporate governance play a significant role in its long-term success.
Good governance and strong leadership should lead to better decision-making and, ultimately, enhanced shareholder value. In contrast, poor management and weak governance can lead to problems and ethical issues and weigh on a company's performance and reputation.
Good governance and strong leadership should lead to better decision-making and, ultimately, enhanced shareholder value. In contrast, poor management and weak governance can lead to problems and ethical issues and weigh on a company's performance and reputation.
Beyond the company: industry trends and their impact
It’s not enough to look at a company in isolation because the context in which a company operates, i.e. industry dynamics and market trends, can influence a company's performance.
Industry trends: A barometer of the business environment
Each industry is unique - for instance, the technology sector in the UK might be influenced by government regulations, technological advancements, and consumer preferences, while the US healthcare industry is influenced by an almost entirely different set of circumstances.
Market trends: The bigger picture
Broader market trends include economic indicators like GDP growth rates, inflation, interest rates, and even geopolitical events. These elements can affect consumer confidence and spending, which in turn impacts business revenues and profits.
Earnings and revenue analysis in light of market trends
A company might show strong revenue growth, but if this is during a period of overall economic expansion, where most companies are growing sales, the achievement might be less significant. Conversely, maintaining stable earnings during economic downturns is one of the best indications that a company has resilience and sound management.
Key ratios and metrics: Tools for smart analysis
Ratios and metrics distil complex financial data into simpler terms, allowing for more straightforward comparisons between companies, even across different industries. This section focuses on some of the most critical ratios and metrics that are widely used in fundamental analysis, namely:
- Price-to-earnings (P/E) ratio
- Price-to-book (P/B) ratio
- Debt-to-equity ratio
- Return on equity (ROE) and return on assets (ROA)
- Dividend yield and payout ratio
Price-to-Earnings (P/E) Ratio: Valuing earnings
DEFINITION
The Price-to-Earnings, or P/E ratio, compares a company's current share price to its per-share earnings.
A higher P/E ratio might suggest that investors are expecting higher earnings growth in the future compared to companies with a lower P/E ratio. However, the context is key; a P/E ratio should be compared against other companies in the same industry or against the company's historical P/E.
Price-to-Book (P/B) Ratio: Assessing net asset value
DEFINITION
The Price-to-Book, or P/B ratio, compares the market value of a company’s stock to its book value (the value of its assets minus liabilities).
A lower P/B ratio can indicate a potentially undervalued stock, but it's important to understand why the company is valued as such by the market.
Debt-to-Equity Ratio: Financial health indicator
DEFINITION
The Debt-to-Equity ratio indicates the proportion of equity versus debt used to finance the company's assets.
A high ratio might suggest that a company is too aggressively financing its growth with debt, which can be risky if not managed well.
Return on Equity (ROE) and Return on Assets (ROA)
DEFINITIONS
Return on Equity (ROE) assesses a company's ability to generate profits from its shareholders' equity.
Return on Assets (ROA) measures how efficiently a company can manage its assets to produce profits.
Return on Assets (ROA) measures how efficiently a company can manage its assets to produce profits.
These metrics are crucial in evaluating the effectiveness of a company's management in generating returns.
DEFINITION
The dividend yield is how much a firm pays out in dividends each year relative to its stock price, while the payout ratio shows the proportion of earnings paid as dividends.
Two complimentary sides of fundamental analysis: Quantitative and qualitative perspectives
Fundamental analysis is not solely about crunching numbers. It involves a balanced approach, integrating both quantitative and qualitative aspects.
Quantitative fundamentals: The power of numbers
DEFINITION
Quantitative analysis revolves around concrete, numerical data found in financial statements.
This includes analysing metrics such as earnings, revenue, and various financial ratios as we discussed above. These numbers provide an objective basis - largely uninfluenced by human bias - to evaluate a company's financial health and performance.
Qualitative fundamentals: Beyond the numbers
DEFINITION
Qualitative analysis focuses on the non-measurable aspects of a company.
This includes evaluating the quality of a company’s management team, its brand strength, competitive advantages, corporate governance, and market position. For example, a company with a strong, visionary leadership team may be better positioned for long-term success, even if current financial metrics do not fully reflect its potential.
Integrating both perspectives
While quantitative data provides a snapshot of the current financial standing, qualitative analysis offers insights into the future growth prospects and sustainability of a company. It’s akin to reading a story – the numbers set the scene, but the qualitative elements provide depth and context.
For example, a company with solid financials (quantitative) but poor management quality or ethical issues (qualitative) might not be a wise long-term investment. Similarly, a company facing temporary financial difficulties might be a good investment if it has strong fundamentals, like a robust business model and competent management.
For example, a company with solid financials (quantitative) but poor management quality or ethical issues (qualitative) might not be a wise long-term investment. Similarly, a company facing temporary financial difficulties might be a good investment if it has strong fundamentals, like a robust business model and competent management.
Fundamental analysis approaches: Different types and tools
Fundamental analysis is not a one-size-fits-all approach; it varies depending on the objectives and preferences of the investor. This diversity in approaches and the tools used is what makes fundamental analysis a versatile and valuable technique in stock evaluation - but it also means there are always new things to learn!
There are primarily two types of fundamental analysis: top-down and bottom-up.
The top-down approach begins with a macroeconomic perspective, analysing global and national economic indicators before drilling down to specific industries and companies.
The bottom-up approach starts with the company itself, focusing on individual business performance, financial health, and management quality, then later thinking about big-picture economics.
There are primarily two types of fundamental analysis: top-down and bottom-up.
The top-down approach begins with a macroeconomic perspective, analysing global and national economic indicators before drilling down to specific industries and companies.
The bottom-up approach starts with the company itself, focusing on individual business performance, financial health, and management quality, then later thinking about big-picture economics.
Practical steps: Conducting fundamental analysis of stocks
Breaking your analysis down into manageable steps makes things a whole lot more approachable. Here's a practical guide to help you get started with a fundamental analysis of stocks:
1. Analyse financial statements
Begin with a thorough review of the company's income statement, balance sheet, and cash flow statement. Look for trends in revenue, earnings, expenses, and cash flow. Pay attention to the debt levels and how they are managed, as indicated by the debt-to-equity ratio.
2. Evaluate financial ratios and metrics
Next, calculate and interpret key financial ratios. The P/E ratio, for example, can give you an idea of how the market values the company's earnings. The P/B ratio provides insight into how the market values the company's assets. ROE and ROA offer perspectives on the company's efficiency in generating profits.
3. Consider dividend history
If you're interested in dividend-paying stocks, examine the company's dividend history and payout ratio. Understand how consistent the dividends have been and what they say about the company’s financial health.
4. Assess management quality and corporate governance
Research the company's leadership and governance structures. A strong, ethical management team is often a good indicator of a company's potential for long-term success.
5. Understand industry and market trends
Analyse the industry in which the company operates and the broader market trends. This will help you understand external factors that could impact the company's performance.
6. Put it all together
Finally, combine all your findings. Look at the company from both a quantitative and qualitative perspective. Limit your investments to the very best opportunities where you are highly satisfied with all the above criteria. While the investment may still not work out due to unforeseen circumstances, you’ll be putting the odds firmly in your favour.
Recap
From decoding financial statements to the significance of industry and market trends, this guide may help you navigate through financial analysis. At this point, you should have a foundational grasp of fundamental analysis, empowering you with the knowledge to assess a company's intrinsic value and make some informed investment decisions.
FAQs
Q: What are the types of fundamental analysis?
Top-down and bottom-up. The top-down approach starts with a macroeconomic perspective, analysing overall economic and industry trends before focusing on individual companies, whereas the bottom-up approach begins with an in-depth analysis of individual companies, considering their financial health and market position before considering broader market trends.
Q: What are the tools for fundamental analysis?
These include financial ratios like the Price-to-Earnings (P/E) ratio, Price-to-Book (P/B) ratio, Debt-to-Equity ratio, Return on Equity (ROE), and Return on Assets (ROA). Additionally, qualitative tools like management assessment, brand strength evaluation, and industry trend analysis are also vital, along with software and platforms for financial data analysis.
Q: How do you do a fundamental analysis of stocks?
Start by examining a company's income statement, balance sheet, and cash flow statement. Next, analyse key financial ratios and metrics, assess dividend history and policies, and evaluate the quality of management and corporate governance. Finally, consider industry and market trends to understand external factors affecting the company.
Q: Why is fundamental analysis important?
Because it helps investors assess the intrinsic value of a stock based on financial and economic factors. It provides a comprehensive understanding of a company's financial health, management quality, and future growth prospects, enabling investors to make informed decisions and identify long-term investment opportunities.
