When it comes to picking stocks, there are two approaches you should/can take technical analysis and fundamental analysis. In this article, we will explain the fundamental analysis.
What is fundamental analysis?
Fundamental analysis is a methodology of techniques used to identify trading opportunities through analyzing trends with an emphasis on patterns. Investors use fundamental analysis to calculate a stock’s actual value. Using publicly disclosed metrics, you calculate whether or not a company could be a profitable investment.
These numbers typically come from three separate but related reports that a public company publishes in quarterly or annual reports to its investors: the balance sheet, the income statement, and the cash flow statement.
The balance sheet summarizes a company’s assets (resources that have economic value to the company), liabilities (obligations that the company has to pay), and equity (the net worth of the company). The formula that ties these three aspects of a business together is as follows: Assets = Liabilities + Equity
The income statement (also known as the income statement) supplements the balance sheet in an annual report. It shows the company’s income and expenses over a specific period of time. Measures reported on an income statement include sales (or earnings), earnings, and earnings per share.
The cash flow statement looks at how money flows in and out of the company. Although similar to the income statement mentioned above, the cash flow statement is less of a performance report and more of an accounting matter. Cash flows typically come from three areas of the business: operations, equipment, and financing.
All three reports are typically found in a company’s annual report to remain transparent to shareholders and the public. These show how the company is doing. More complicated models can also include external factors, such as B. include macroeconomic conditions or tax policy. For this introduction, however, we will limit ourselves to an analysis using only company data.
The reasons for doing fundamental analysis
Fundamental analysis is essential for evaluating stocks and is mainly used for long-term development forecasts. For this purpose, a company’s balance sheet data is usually viewed over several periods and compared with one another.
In addition to balance sheet ratios, earnings ratios, and valuation ratios such as the dividend yield, economic data from the company’s industry are also critical fundamental data that are used as ratios for evaluating shares. Fundamental data analysis is a popular tool for strategic investment success.
After analyzing, for example, the price-earnings ratio, sales growth, earnings per share, and other fundamental key figures, forecasts are made for the company’s further development. Based on these findings, a trader tries to estimate the future development of the share.
In addition to technical analysis or chart analysis, which evaluates stocks based on past stock prices, fundamental analysis is the most important tool for making data-based trading decisions in the stock market.
The importance of fundamental analysis
Fundamental analysis is essential for a successful trading strategy, from the definition to the explanation of the individual steps to practical trading tips with which you can apply fundamental analysis professionally to your personal trading strategy.
Fundamental analysis requires a basic understanding of company data. Although tools in trading platforms provide access to many company key figures, these must always be evaluated by an analyst and placed in the proper context.
Fundamental data always stands together because only comparing this data with figures from previous quarters or years and comparing this data with the economic figures of other companies enables a correct evaluation.
Fundamental analysis is not rocket science, as, unfortunately, far too many believe. The information you need as an investor is easily accessible on the Internet, and the crucial aspects can be learned quickly. In this article, we explain what you need to know about these things to form your own opinion and not be dependent on the interpretations of others.
Where to find data for fundamental analysis
A wealth of information about public companies can be easily found online. Some of these stats (like the number of employees and profit) are self-explanatory. But there are also more complicated numbers and metrics that are meant to provide an interpretation of some aspect of a company’s financial performance. We’ll go through a few of the most popular ones here.
Market capitalization
Market capitalization is the total value of a company’s outstanding shares at a given point in time.
Market Cap = Current Share Price * Total Number of Shares Outstanding
This number is important in determining whether a company is classified as large-cap, mid-cap, or small-cap. Large-cap companies are often viewed as having a market capitalization over $10 billion. Mid-caps have market caps between $2 billion and $10 billion, while the small-caps range from $300 million to $2 billion.
Earnings per share
Earnings per share (EPS) is the number of earnings per share of the company’s outstanding shares. As the name suggests, this would be the total value each share brings to the company. An EPS of CHF 5 means that each share issued brings the company CHF 5 in net profit.
Earnings per share = (net income – preferred dividends) / average shares outstanding
Since there is no general guideline, the EPS is open to interpretation. A high EPS is a sign of high yields.
For more meaningful results, the focus should be on a long-term analysis to see the company’s earning power over time and a review of the EPS of other companies in similar industries.
Dividend per share
Like EPS, dividends per share (DPS) is a metric that provides an easy way to calculate a company’s earning power. DPS is t is the number of dividends paid per share.
Dividend per share = (Total Dividends – Special Dividend) / Average Shares Outstanding
Price-to-earnings ratio
Perhaps the most well-known of all metrics is the price-to-earnings, or P/E, ratio. P/E is expressed as a multiple of the company’s stock price relative to its earnings per share. The P/E ratio is also known as the price multiple or P/E ratio. Price to earnings ratio (P/E) = share price / earnings per share
For example, if a company’s share price is trading at $10 and the calculated EPS is $2, the company’s P/E is 5.
Return on Equity
The last of the metrics is the return on equity. Return on equity is the ratio of income to outstanding equity. It shows a company’s profitability (earning power), which is generated from the capital employed.
Return on equity = net income/shareholder equity
For example, if a company generates $10 million in total revenue in a year when equity is $25 million, then the return on equity would be 40%.
Like the other metrics, ROE is best examined about a company over time and about an industry. A company with an increasing return on equity over time may indicate an increase in efficiency (higher profits with lower capital expenditure).
Limitations of fundamental analysis
Fundamental analysis is a method that has its limitations. One of them is the fact that the Efficient Market Hypothesis (EMH) contradicts this method. This economic principle states that market prices reflect information from the past. Therefore, analyzing trends while focusing on patterns needs to be clarified.
Added to this is the self-fulfilling aspect of fundamental analysis. If enough people use the same signals and inputs to decide which stocks to buy, they could cause the expected move themselves. This would create a snowball effect.
Finally, it is essential to understand how fundamental analysis works before using it with actual money to avoid losses. It’s a good idea to experiment with a range of strategies and use the indicators in combination to get meaningful trading results.
It helps to consider how much risk you are willing to take and which products suit your skillset. In addition, investing money that you may need in the short term or taking positions that could lead to financial difficulties is not advisable. It all starts with thinking about what kind of investor you want to be. You can read more about the risks of investing in our investor information material or on our dedicated risk page.
The information in this article is not written for advice, nor is it intended to recommend any investments. Investing involves risk. You may lose money. We advise you to only invest in financial products that you know and have experience with.
