Before you make a trade, you’ve got to build a case for why it’s a good idea — and fundamental analysis should be part of that process.
Fundamental analysis is one of the two key types of stock analysis. The other? Technical analysis.
Truth be told, you’ll probably hear me talk more about technical analysis, which involves looking at historical price action on the stock’s chart to try to determine how the stock might move in the future.
But here’s the thing: Technical analysis doesn’t work without fundamental analysis.
To back up your trading thesis based on the price action, you need to do fundamental analysis, too. This is where you do some detective work into the company offering the stock. You evaluate its financial health and any business developments or news related to the company that could affect the stock price.
By digging into the company’s fundamentals, you can gain access to information that works alongside your technical analysis. That can give you a broader view of the stock’s potential and help you make better trading decisions.
So … what exactly is fundamental analysis, what sorts of tools should you be using, and how can you use it to choose stocks to trade? We’ll cover it all in this post.
Table of Contents
- 1 What Is Fundamental Analysis?
- 2 Fundamental vs. Technical Analysis
- 3 6 Fundamental Analysis Tools
- 4 Conclusion
What Is Fundamental Analysis?
Fundamental analysis is a way to try to measure a stock’s intrinsic value. It involves looking at the company’s finances, the economy, and other direct and indirect factors relating to the company.
To conduct fundamental analysis, you want to look at anything and everything that could affect a stock’s price and value…
Yes, this includes company-specific factors, such as a new product, earnings, and expenses.
But it also includes things that may not be company specific but that could still impact the stock’s price — changes in the economy (trade war, anyone?) or legislation that could affect the company or stock in question.
Typically, fundamental analysis relies heavily on things like balance sheets, cash flow trends, income statements, and SEC filings.
And it doesn’t stop there. Good fundamental analysis will draw from a variety of sources like press releases, blog posts, and articles in the media.
For example, is the company getting good (or bad) press for an event or product? Did it post profits last quarter, or did its profits dip dramatically? This is stuff you should be finding out in the course of your fundamental research.
Fundamental Analysis of Stocks
How do you actually get started with fundamental analysis? Here are some popular research tools.
Before you can begin to dig deep, you have to identify stocks that are worthy of your attention and your valuable fundamental-analysis time.
By using a stock screener, you can filter based on criteria that you set, like biggest gainers, upcoming earnings, and more. A strong watchlist is fundamental to fundamental analysis.
Public companies are obligated to release financial statements to shareholders. In particular, traders should watch for earnings reports.
Access to a company’s earnings report is kind of like being given permission to read its diary. It can give you important insight into a company’s inner workings.
Earnings are super important because they can be a huge driver of stock prices. If a company exceeds earnings projections, it could create great momentum. On the flip side, disappointing earnings can drive prices down.
Best of all? Earnings reports are free, public, and easy to access. They can give you great information about the company’s finances, performance, and where it might be going in the future.
News can have a big impact on stock prices. Be sure to do a thorough search for any news related to the company in question. Sure, look at the company’s website, but don’t stop at company-issued press releases, because they could be self serving. Also look for mentions in news outlets, blogs, and even on social media.
A good stock screener can help with scanning the news. For instance, StocksToTrade has features beyond just charting software. Ticker pages also include links to relevant company news, press releases, and even social media mentions.
It’s super handy to have access to both technical analysis and fundamental analysis tools on the same platform.
Fundamental vs. Technical Analysis
Confused about the difference between fundamental and technical analysis? Let’s clear that up.
Fundamental analysis looks at the inner workings of the company offering the stock.
In contrast, technical analysis focuses on price action, trends, and patterns. This is where you look at the stock’s historical performance so that you can try to understand how the stock might perform in the future.
Technical analysis focuses on the following:
- Price Action: Also called market action, this is where you look at the stock’s historical movements.
- Price Trends: Over time, prices can fall into trends that you can observe on the stock chart. A trend lasts until something happens that either changes or reverses the trend.
- Stock Patterns: As you know, I love me some stock patterns. The idea behind looking at patterns? History can repeat itself.
Of course, that’s never a sure thing and history usually doesn’t repeat itself to the letter. But it’s often close enough that it’s worth considering. I always look for patterns, because once you notice one with a stock, there’s a chance it may repeat itself sooner or later.
So, to review:
- Technical analysis is when you focus on historical data and price action. Or, as I put it in this post, it’s where you wear your ‘economist hat.’
- Fundamental analysis is where you focus on the inner workings of the business and its financial health — and how that can affect the stock price. Or, it’s where you wear your ‘business hat.’
6 Fundamental Analysis Tools
Ready to dig in and get down to performing fundamental analysis? Here are 6 vital tools to help you do it right.
Earnings per share, or EPS for short, is a super simple – and highly valuable – tool for conducting fundamental analysis. It refers to the amount of a company’s profits allotted to each outstanding stock share.
There are two formulas for computing earnings per share:
- Net Income / Total Number of Shares Outstanding = EPS
- Net Income / Weighted Average of Shares Outstanding = EPS
Read more about the EPS formula in this post.
The price-to-earnings ratio, also called the P/E Ratio, is a popular ratio that lets you look at the relationship between the EPS and the stock price. It can give you an idea of the company’s value and market expectations based on their earnings.
Generally, the P/E ratio is calculated by dividing the stock price per share by the EPS, like so:
Market Value per Share / EPS = P/E Ratio
The price/earnings-to-growth ratio, or PEG ratio, is used to figure out a stock’s value while also taking into consideration the anticipated earnings growth. Some consider it to be a more robust indicator than the P/E ratio alone.
To calculate the PEG ratio, the P/E ratio is divided by the rate of growth of the company’s earnings within a specific time period. So, it might look like this:
P/E ratio / Earnings Growth Rate = PEG
The price-to-book ratio, or P/B ratio, takes into account the current book value per share relative to the stock price. Wondering what the book value is? That’s the total assets of the company, minus outstanding liabilities. This ratio can be an indicator of undervalued stocks.
Calculate the P/B ratio by dividing the stock price by the aforementioned book value. It looks like this:
Market Price per Share / Book Value per Share = P/B Ratio
Dividend Payout Ratio
The dividend payout ratio, sometimes simply called the ‘payout ratio,’ can help you figure out the amount of dividends issued to shareholders relative to the company’s net income.
This ratio helps provide an idea of how much the company will pay shareholders in contrast to how much it’s keeping on hand. While a lower dividend isn’t always a bad thing, especially if the company is using the retained funds to invest in future growth, it can help you get a better picture of the company.
Net Income / Dividends Paid = Dividend Payout
The dividend yield shows the ratio of the annual dividend relative to the per-share price. High yield typically follows high dividends. This can be a sign of high earnings. Of course, this isn’t always the case – it could be because the stock is actually losing value. Learn more in this post about high dividend stocks!
The dividend yield is calculated like so:
Annual Dividend / Current Share Price = Dividend Yield
Return on Equity
Return on equity, or ROE, is a way of measuring a company’s performance based on its net income and shareholders’ equity, or a company’s assets minus debt.
You can use it to help you determine whether the company is effectively using its assets to generate profits. The calculation for ROE goes like so:
Net Income / Average Shareholder Equity = Return on Equity
Fundamental analysis can help you make intelligent and informed trading decisions. By scrutinizing the company offering the stock and looking at its earnings, company happenings/news, and evaluating its overall health, you can get a big-picture view of the stock you’re about to trade.
Of course, fundamental analysis alone shouldn’t be the final deciding factor when entering a trade. Consider a combination of both fundamental analysis and technical analysis, where you look at the stock chart and price action. By looking at a security from as many angles as possible, you can be better informed and better primed to sniff out hot stocks.
There are a lot of things to consider when executing trades. Effectively researching stocks can take time … more time than needed if you’re not sure what you’re doing.
Trading classes can help you figure out the hows and whys that you need to know to manage your trading time most effectively. Looking for a resource to develop these skills fast? Consider joining my Trading Challenge.
In the Challenge, I’ll help you learn the basic concepts of trading while remaining adaptable to the ever-changing markets. With an ever-growing library of DVDs, webinars, and resources like watchlists and commentary on every one of my trades, you can learn to approach the market in your own way, becoming a self-sufficient trader.
I want you to retain your own identity and develop your own style as a trader, so I’m looking for hard-working self-starters who aren’t afraid to work hard.
The only thing I don’t have tolerance for? Laziness. If you think you’re going to watch a DVD, place a few trades, and become a millionaire, think again.
It takes hard work and lots of practice to hit your stride as a trader. This is a demanding profession that requires routine and hard work. Are you ready?
What are your favorite fundamental analysis tools? Leave a comment and let me know!