NOTICE

The information needed to conduct the fundamental analysis shown in these lessons can be found online via your online broker.

Fundamental analysis at its core is an attempt by fundamental investors to value shares of a company based on multiple factors. These factors include current economic trends in the world, trends in the companies industry, and trends of the specific company being evaluated. Fundamental investors will also look at things like company management, how fast the company has grown in the past, the companies balance sheet, and much, much, more.

The end goal of an investor that focuses on fundamental analysis is to come up with a value for what shares of a company should cost and compare them to what they currently cost. Because the price of a companies stock constantly changes, it does not always reflect what the value of the company really should be. If a fundamental investor can find a stock with shares that are priced lower than their analysis says they should be, they can then purchase shares of that stock and wait for the price to rise to match the true value of the company.

Financial Statements

The majority of information used in fundamental analysis comes from the financial statements that publicly traded companies release. The SEC has very specific guidelines and rules for companies with shares on the stock market. They are required to release their quarterly earnings four times a year, make significant announcements in a fair way so that no investors hear the news first, and follow quite a few more regulations.

Each quarter when a company releases their earnings they will release three important documents. The balance sheet, the income statement, and a statement of cash flows.

Balance Sheet

The balance sheet is simply a screen shot of the companies financial status at the time the balance sheet was created. Fundamental investors use the balance sheet to see how many assets a company owns and compare it to the companies liabilities. Assets are essentially things with value. Some asset examples include property, cash, and debts that are owed to the company. Liabilities are essentially debts and payments that the company will have to pay at some future date. Nearly all companies carry some sort of debts. Do not assume just because a company has a lot of debt that their value will not continue to climb.

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investing fundamentals

Income Statements

An income statement is not a screenshot of a moment in time. Instead it looks at a specific period of time, such as a quarter or year, and breaks down how much money the company made and how much it spent during that period. Fundamental investors can use an income statement to see how much money a company is making and then compare it to previous periods to see how quickly a company is growing. The statement also gives a good idea of what the company is spending their money on and how much profit a company is actually making. Some companies can bring in quite a bit of money, but due to expensive operating costs, never actually manage to make profit. As with balance sheets, a companies that is not profitable will not necessarily see their stock prices go down. Some companies such as Amazon rarely turn a profit in a quarter, but are valued at billions of dollars because of things like their assets, branding, etc. They choose to spend a lot of money on growth, which will bring more value to the company in the future.

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fundamental analysis

Statement of Cash Flows

The statement of cash flows is somewhat similar to an income statement with a few key differences. This statement reports on money that actually went in and out of the business during a specified time period. The income statement uses an accounting method called accrual accounting. What this means is that they can report income and expenses that actually haven’t happened yet. This can be tricky to understand for fundamental investors, and thus can be clarified by a statement of cash flows.  A statement of cash flows can be hard to grasp, but luckily there are plenty of sources online available to teach more about this statement.

cash flows for fundamental investors
fundamental investing

Ratios

One of the most valuable pieces of information fundamental investors can gather from financial statements are ratios. Ratios allow you to compare two metrics from the companies financial statements such as share price, company earnings, or growth rate. In fundamental analysis, ratios are typically used to compare the current share price of a stock to another aspect of the company and get an idea if a company is currently being overvalued, undervalued, or fairly valued. Be careful not to focus on any one metric. A good fundamental investor will look at many different metrics and purchase stock in companies that seem to be undervalued across the board.  Here are a few of the most commonly used ratios, where to find the information, and how to use them.

Price/Earnings Ratio

P/E = share price / annual earnings per share

The price to earnings ratio, commonly known as the P/E ratio, tells a fundamental investor how much it would cost to own $1 of a company’s earnings. While this may sound a little confusing at first, it is quite simple. If the current price of a company’s stock is $10, and that company makes $1 per share, per year, then their P/E ratio would be 10 (10/1). The annual earnings per share can be calculated by taking a companies yearly earnings off the income statement, subtracting dividends, and dividing it by the total number of outstanding common shares.

Luckily the P/E ratio usually will not have to be calculate by you. Most brokers, and multiple websites will do that for you. Another great tool to calculate the ratio is Yahoo Finance.

Typically a lower P/E ratio is good. That means that the company is making a lot of money for each share of stock they have, and your ownership in that stock has solid earnings behind it. There is no specific point where a P/E ratio becomes “good” or “bad” because there are a lot of factors besides earning that need to be looked at. Apple, for instance, has P/E ratio at the time of this lesson of about 10. Action camera maker, Go Pro, has a P/E ratio of 50. However, Go Pro is growing at a much faster pace then Apple, so even though they don’t make as much per share, their growth shows that maybe they will in the future.

A good fundamental investor will look at other similar companies and competitors in the industry to see how the company stacks up. If a company is growing at a similar rate to another, and they are in the same industry, but one has a much lower P/E ratio, there is a good chance the one with the lower ratio is a better investment.

PEG Ratio

P/E Ratio/Annual Earnings Per Share Growth

PEG ratio stands for Price Earnings Growth. This is a method of fundamental analysis that compares the price to earnings ratio explained above to the growth rate of a company. This helps an investor to see how much the company currently makes per share, and then compare it to how fast the company is growing. The lower a PEG ratio is, the better chance it has of being a good buy because it means the company has a lot of growth compared to its current earnings. A company with a high PEG ratio is likely overvalued and the stock price will eventually fall.

In the Apple/Go Pro example above, Go Pro has a PEG ratio of .9, while Apple has a PEG ratio of 1. Some would argue that this makes Go Pro a slightly better buy. They would reason that Go Pro makes less earnings per share, but is growing at a much faster rate and thus will make a better long term investment for fundamental investors.

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Debt to Equity Ratio

Liabilities/Equity (balance sheet)

This ratio is so important for fundamental investors because it gives a quick look at how the company is financing its growth. It is comparing how much of a company is owned by creditors and banks with how much equity you as a stockholder will actually get. If a company’s debt to equity equity continues to increase, it means that the company is financing its operations more and more with debt, rather then its own resources and profits. This can be dangerous, and eventually creditors will be unwilling to offer financing and the company will find itself in serious trouble.

While it is important to know how to calculate this ratio, there are dozens of resources that twill calculate this ratio, and others, for you. Our favorite is Ycharts, though they only offer 10 free checks a day.

As with other ratios, there is no single number that makes a good debt to equity ratio. Instead, a good fundamental investor will compare a company to its competitors and its industry. If two similar companies with similar products have very different debt to equity ratios, you will likely be better off going with the lower one.

A good example of what can happen with high debt to equity ratios is the solar company SUNEQ 0,04 -0,00 -8,26%. SUNE financed their growth with extreme debt, eventually selling shares of their company at around $30 a share. Their debt to equity ratio was around 75 (their competition was averaging 8-10). As investors began to realize that Sun Edison couldn’t sustain their company with the current business model the stock price started to free fall. Within 8 months the price had fallen from $30 a share to 45 cents a share. Investors lost millions. Doing a simple debt to equity ratio check can save a fundamental investor from a lot of financial pain.

Where to Start

Fundamental analysis is one of the most rewarding ways to invest, but requires a lot of work up front to understand what is really going on in a companies financial statements. This course was designed as an intro to fundamental investing. To learn more and begin your journey as a fundamental investor check out our market courses page and choose a fundamental analysis course that is right for you.