Fundamental Analysis

Fundamental analysis is the study of a company’s financial details in order to determine whether the company would make a good investment or not.

Introduction to Fundamental Analysis

Here’s a quick run down on what it is and how to perform it.

What is Fundamental Analysis?

Does this company have a history of making money? Is the company well run? Does the company’s management have debts and cash flows under control?

And most importantly . . .

“Is it likely that this company’s stock will be appreciated by the market, in particular, the large financial institutions that have the power to push share prices up?”

Let’s have a look at some fundamentals…

Profitability

A good company makes lots of money on an ongoing basis. In the long-term, earnings drive share prices. Profitability matters to a lot of investors.

Two effective measures of profitability are:

  • Free Cash Flow
    It’s the left-over cash after all the bills are paid. The fact that a company has free cash flow is a good sign. A company with a lot of free cash flow is even better. Some investors consider free cash flow to be the best measure of a company’s profitability.
  • Return On Capital (ROC)
    Measures how efficiently the company’s management is using the capital tied up in the business.

Note: In the place of Return On Capital you could use Return On Assets or Return On Equity. All of these metrics measure efficiency. The key is to use a valid minimum threshold value. Say 8% for ROA, 10% for ROC, and 15% for ROE.

Growth

As a company grows, so too does the share price (as long as that growth is substantial).

Growth can be assessed by looking at the following two items together:

  • Earnings growth, and
  • Sales (i.e. revenue) growth

It’s good to look at sales and earnings growth together. When profits are driven by sales you know that the company is doing well.

Strong earnings growth seems to have a strong correlation to share price growth. If you are using fundamental analysis to add weight to a mostly technical analysis based trading style, look for year-on-year (i.e. past year’s) earnings growth greater than 25%.

Financial health

We need to know that the companies we’re investing in are not overburdened with debt or burning cash.

We can look at the following items to assess a company’s financial health:

  • Debt/Equity ratio
    By comparing a company’s debt to its equity you can get a measure of the company’s indebtedness. I look for ratios less than 70%.
  • Interest Coverage ratio
    Interest Cover tells us how easily (or otherwise) a company is able to repay the interest on its loans. A ratio of 3 times means that the company’s earnings before interest and tax (EBIT) is 3 times greater than its interest expense – this is a good sign.
  • Positive cash flow
    If a company’s cash flow from operations is positive it means that the company has more money coming in than going out.

Valuation

What is this company worth? How much should I pay for this company’s shares?

Value investors attempt to determine a fair value for a particular business. Then they purchase shares in the company when the total value of all the shares for sale in the market is less than the value of the business. In this way, value investors consider that they are buying the stock at a bargain. They believe that eventually the stock price will rise back up to fair value, in which case they will sell their shares for a profit.

Two very good valuation measures for value investors are:

  • Free Cash Flow Yield
    Free cash flow yield is calculated by dividing free cash flow by enterprise value. The higher the free cash flow yield the cheaper the stock (free cash flow yields greater than 10% are a good starting point).
  • Enterprise Value / EBITDA
    A company’s enterprise value is what someone would pay if they wanted to buy a publicly listed company to make it private. EBITDA stands for Earnings Before Interest Tax Depreciation and Amortization. EBITDA is a profitability measure. The lower the enterprise value to EBITDA multiple, the cheaper the stock. Look for multiples between 4 and 8.

Note: Some traders, using a mostly technical analysis approach to the market, believe that a share is worth what someone else is willing to pay. They pay no attention to stock valuations.

Summary

Behind every stock there is a company. Fundamental analysis is used to analyze the company from a financial point of view to determine whether the company is worth investing in.

Share prices often reflect the strength of a company’s fundamentals.

When will the stock market appreciate the stock’s fundamental strength? That’s where technical analysis comes in. Fundamental analysis helps you to choose the companies with the best prospects. Technical analysis tells us when to buy and when to sell.

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