Fundamental analysis of stocks is the bedrock of long-term investing. Fundamental analysis is a critical component used by stock investors to determine if the current stock price reflects the actual current value of a company. This fundamental analysis for dummies guide will teach you how to take a stock fundamental view from your analysis and translate that into a trade.
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There are many different ways to think about how to trade stocks, but broadly speaking, there are two major schools of thought: fundamental vs technical analysis. Once you learn how the stock market works and how the valuation of a company is done you’ll understand why fundamental analysis is important.
The basic goal of stock fundamental analysis is to find the stock’s intrinsic value. This will help you determine whether or not a stock is undervalued or overvalued. Now, you see why stock picking using fundamental analysis can be of tremendous help.
The US stock market size is now $30 trillion and most Americans are participants in the stock market. However, most of these investors are not actively trading the stock market. They’re invested in the long-term growth prospective of a company.
The purpose of this fundamental analysis guide is to educate investors on the importance of fundamental analysis.
Let’s start with the basics, and define what is fundamental analysis?
What is Fundamental Analysis?
In the financial world, fundamental analysis is the concept of investigating the financial statements of a company to help determine if its stock is a good investment opportunity. For stocks, financial statements include revenues, future growth, balance sheets, income statements, profit margins, cash flow statements, and other relevant data.
These financial factors can help investors assess the intrinsic value of the stock. There are many types of fundamental analysis that uses these financial factors to help evaluate a company.
Basically, the process of fundamental analysis involves studying qualitative and quantitative financial matters in order to discover the stock’s fair value. That’s why we can distinguish two types of fundamental analysis:
- Quantitative analysis.
- Qualitative analysis.
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A classic fundamental analysis example is when a stock investor examines the balance sheet of a company. The components of a company balance sheet will give you a snapshot of the following three items:
- Assets, which are the things the company owns (cash, equipment and property).
- Liabilities, which are the debts the company needs to pay.
- Owners’ equity or the capital, that represents the money raised through an Initial Public Offering IPO or in a secondary offering.
The above-mentioned process of fundamental analysis is a form of quantitative analysis, which uses measurable elements of a company. The qualitative analysis uses less tangible elements surrounding a company like brand name recognition or board members.
Fundamental analysis should answer all the question surrounding the health of a company:
- Is the company making a profit?
- Are the company’s sales growing?
- How is the future outlook of the company?
- How are economic changes going to impact the growth scenario for the company?
The bottom line is that stock fundamental analysis incorporates everything related to the economic health of a company. You may also be interested in this Futures Trading Strategies for Dummies guide.
There are many financial books written by some of the most successful investors of all times that can help you advance your understanding of how to analyze stocks using fundamental analysis.
So, what are the best fundamental analysis books?
The “An Intelligent Investor” and “Security Analysis” books written by Benjamin Graham are considered on Wall Street to be the bible of fundamental analysis of stocks and value investing. Warren Buffett thinks everyone should read An Intelligent Investor, which is his top stock book recommendation. Buffett is the most successful investor of all times so he must know something.
Let’s examine the advantages of stock fundamental analysis.
Why use Fundamental Analysis in Stock Trading?
Stock market fundamental analysis is an essential component of the long-term stock trading strategies used by the smart money on Wall Street. Long-term growth investors have profited big time taking positions in stocks based on fundamental analysis.
It’s well known that hedge funds tend to attract the smartest people in the world. We’ve revealed some of the fundamental analysis tools used by long-term stock investors here: Hedge Fund Strategies and Tools Used on Wall Street.
Behind any strong stock bullish trend, there is usually a big fundamental force that drives and fuels that stock market trend. Knowing what are those stock fundamental drivers will help you better ride the long-term trend. The fundamental drivers are not just some ephemeral forces, but they are long-lasting drivers that can confirm if a stock is a safe investment or not.
So, if you want to hold your stock for the long-term, then it’s essential to understand the importance of fundamental analysis.
When it comes to stock trading there are two major schools of thought used by stock traders to gain a competitive edge in the market.
So, we’re going to outline which one is better for finding trading opportunities in the stock market, fundamental analysis or technical analysis?
To better understand the difference between technical analysis and fundamental analysis, check out a practical example of How to Apply Technical Analysis, Step by Step.
Fundamental vs Technical Analysis Which is Better?
The debate around the fundamental vs technical analysis subject has caught up many traders. Too much writing ink has been consumed either in favor of fundamental analysis, technical analysis or some kind of combination between the two.
The CAN SLIM method, developed by investor William O’Neil uses a combination of technical and fundamental analysis to help you pick the best stocks. Learn the secrets of CAN SLIM strategy here: How to Make Money in the Stock Market.
Moving forward, we’re going to have a look at the key differences between the two concepts used to analyze stocks.
The process of fundamental analysis is more suitable for long-term investing while technical analysis is more suitable for short-term trading strategies. This basically answers the question when to use fundamental analysis?
Instead of analyzing financial statements, technical analysis is more concerned with analyzing the stock price chart. From the perspective of an equity investor, the goal of fundamental analysis is to pick stocks with the right valuation and that have the potential for growth. On the other hand, technical stock traders are only concerned with finding a profitable stock trade signal. They accomplish this by using various technical indicators, chart patterns, tape reading or a combination of them.
In essence, both fundamental analysis and technical analysis try to tackle if a company’s stock is cheap or whether it’s expensive. They try to find an answer to this question from different directions.
In the end, it all comes down to your personal preferences and your type of personality. Legendary Wall Street trader Martin Schwartz, who won the US Investing Championship in 1984 and the author of “Pit Bull: Lessons from Wall Street’s Champion Day Trader,” said:
“I always laugh at people who say “I’ve never met a rich technician” I love that! Its such an arrogant, nonsensical response. I used fundamentals for 9 years and got rich as a technician”
Check out the top stock trading quotes of all time and learn from successful stock traders HERE.
Moving forward, we’re going to reveal how to choose stocks using fundamental analysis. The best parameters for stock selection
How to Pick Stocks Using Fundamental Analysis
You need to learn the 5 most important parameters for stock selection before making any stock investment. These are key financial ratios you must look at before making a stock trade.
These five stocks criteria will reveal how valuable the stock is and if it has growth potential. This is not a foolproof method or the Holy Grail of stock investment. But, when you look at the stock financial ratios you can assess the health of the company.
Below are the five financial ratios that one should look at before investing in a stock:
- P/E Ratio (price-to-earning ratio).
- ROE Ratio (return on equity ratio).
- P/B Ratio (price to book ratio)
- Debt/ Equity Ratio.
- Profit Margins
While there are other stock financial ratios we only highlighted the key financial ratios you must look at before making a stock investment. Understanding key investment ratios for stock picking can help you pick growth stocks for your portfolio. Every investor should use the above-mentioned stock financial ratios if you want to build a profitable stock portfolio.
Let’s break down all these terms and see what parameters to use for the initial stock scanning.
#1 Price to Earnings Ratio
The price to earnings ratio is a way to calculate how much you need to invest in order to receive one dollar of that company’s earnings. The P/E ratio is probably the first thing investors look for when evaluating a company.
P/E = Price per Share / Earnings per Share
For example, if a stock is currently trading at $100 and the earnings in the last year were $4, the P/E ratio would be $25.
What’s a good price to earnings ratio?
It all depends relatively to what other stocks from the same sector are doing. Generally, we want low P/E ratio stocks compared to other companies from within the same sector.
#2 Returns on Equity Ratio
The ROE ratio is another type of profitability ratio that measures how effective a company is in relation to equity. The return on equity ratio shows how a company generates a profit compared to the money that’s invested. This is an important metric because it shows how well a company uses investments.
ROE = Net Income / Owner’s equity
The investor should look at the ROE trend for minimum of 5 years and it should be greater than 20%.
#3 Price to Book Ratio
Warren Buffet’s simple formula for picking stocks includes the price-to-book ratio, also known as the “Margin of Safety.” Buffet learned this concept from the father of fundamental analysis Benjamin Graham. According to Warren Buffet, the best way to calculate the value of a company is to add the percentage of net profit to the percentage of dividends paid and divide that sum by the P/B ratio.
We can distinguish 3 bullish scenarios from the stock P/B ratio:
- If the ratio is above 10, the stock is expected to double in value.
- If the ratio is above 15, the stock is expected to triple in value.
- If the ratio is above 20, the stock is expected to quadruple in value.
#4 Debt to Equity Ratio
The debt to equity ratio is also known as the leverage ratio and it measures the degree to which a company is financed with debt. The more debt a company has, the more it will eat into the cash flow of a company. The more debt a company has on its balance sheet it becomes inherently more risky stock.
Debt to Equity Ratio = Total Liabilities / Shareholder’s Equity
The parameter for the debt to equity ratio should be less than 1.
#5 Profit Margins
The profit margin ratio is used to determine how profits are generated from sales revenue. Basically, the stock profit margins show the degree to which a company makes money and how profitable is. For example, if a company reports a profit margin of 40% during the last quarter, it means that has generated $0.4 net profit for each dollar of sales generated.
Profit Margin = Net Income / Sales Revenue
Stock investors should look back at least five years to gauge if the profit margins are in an ascending trend.
According to Warren Buffet, this is the best way to calculate the value of a company. Warren Buffet’s stock investment strategy uses these financial ratios to pick stocks with growth potential. You can easily use a stock screener to save time and effort in your quest for finding the most fundamentally sound stocks to buy.
Final Words – Fundamental Analysis for Dummies
It’s well-known that most successful hedge fund managers are educated and on top of their game. The fundamental analysis of stocks is another weapon in the trading arsenal used to make educated and intelligent stock investing decisions. There is no best way to invest between fundamental vs technical analysis. In the stock market, it’s very possible that a stock may not have a tradable technical pattern, but fundamentally, the stock company is quite strong.
Fundamental analysis is not restricted to investing in the stock market. They are used by lots of different types of traders (Forex traders, Futures traders, Cryptocurrency investors). Throughout this fundamental analysis for dummies guide, we focused more on the equity market because fundamental analysis is better suited to pick growth stocks.
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