With the macro side of fundamental analysis done, it’s time to look at how you determine the fair value of a stock.
At the beginning of this course, we covered how fundamental analysts often take a top-down approach to research. They start with an overall economy, before drilling down to individual markets.
In this lesson, we’ll take a look at the latter half of that process.
Before taking a deep dive on an individual stock, you’ll want to get an overall gauge of how different sectors are performing. Not only does this help when comparing individual companies, it gives you a holistic view of the markets too – a win-win.
Essentially, in sector analysis you’re looking to establish some performance benchmarks and get an idea of where companies in an industry are headed overall.
Some sectors will perform better in some business cycles than others. People still need food even in a recession, for instance, making it a sector that can be resistant to economic downturns.
You’ll also want to understand the supply chain and production processes for the companies involved. For example, biotech companies can take a long time to get their products to market, with lots of regulation to get through. So just because you’ve found a biotech firm with an exciting new drug, doesn’t mean you’ll see profits overnight.
A few other factors to consider for sector analysis include:
- Whether government regulation might impact the sector, for better or worse
- General P/E ratios for stocks within the industry (we’ll cover these below)
- General profit margins for the industry
- Other metrics that may be specific to the sector, such as user metrics for software companies
Once your sector analysis is complete, you can move on to choosing some individual companies. And the main source of stock fundamentals are earnings reports.
Earnings reports form the heart of fundamental analysis for stocks. They’re typically released on a quarterly basis by listed companies and contain a wealth of data on recent performance. Most listed companies will release a more comprehensive report once a year, too.
Earnings reports tend to be broken down into three sections: a company income statement, balance sheet and cash flow statement.
1. Company income statement
The income statement is where a firm reports its revenues, costs and net earnings – and includes various calculations of a company’s income too. Both quarterly and annual reports are important, as they will help you to see whether the company is meeting expectations and how it is performing on a year-to-year basis.
An income statement is usually made up of the following:
- Net profit
- Gross margins
- Earnings per share (EPS)
- Interest payments
All the sales the company has generated, before any costs are subtracted.
How much the company has spent on earning revenue, including cost of goods sold (COGS). This is a key metric, as if costs are rising faster than profits, it can be a warning sign.
Revenue minus expenses, also known as income or earnings.
How much money the company is making from its sales before you subtract operating costs.
What is gross margin ratio?
Gross margin ratio is a percentage figure that can be calculated by dividing gross profit by net sales. The higher it is, the more efficient the company is in making profit.
Total profit divided by the number of outstanding shares. This tells you how much a company makes for each share it has available and is a key metric measuring profitability.
Payments on short- and long-term loans. This can be used to calculate the interest coverage ratio – dividing earnings before interest and tax (EBIT) by interest expenses will provide an idea of how likely it is a company will go bankrupt. A low ratio means that a company is having problems meeting its debt repayments.
2. Company balance sheet
The company balance sheet provides you with a snapshot of a stock’s assets and liabilities at a particular point in time. This includes:
- Shareholder equity
- Assets vs liabilities
Everything a company owns.
Debt or any other claims on a company’s assets made by its debtors.
All the claims made by owners or shareholders of the company.
The balance sheet is called this because a company’s assets and liabilities (plus shareholder equity) should balance one another. Assets and liabilities will be listed on a balance sheet according to their level of liquidity – so current assets, those that are most disposable, would include cash and anything else that the company can quickly turn into cash.
How has the business been performing over time?
A single year’s worth of figures won’t show much – by assessing a company’s figures over a longer period, you will get a better idea of how a company is performing vs its competitors.
3. Cash flow statement
Finally, the cash flow statement contains information on how a company is generating the money it needs to cover its expenses, investments and debts. It’s not the most glamourous section of an earnings report, but it does provide a useful indication of whether a business has solid financials – plus how it is spending its cash.
A cash flow statement will comprise of three components:
- Operating activities. Any sources or uses of cash from regular business operations
- Investing activities. Capital used to invest in the long-term future of the company
- Financing activities. Cash from investors or banks, as well as money paid to shareholders
Financial ratios analysis
To get a better idea of a company’s fundamentals, analysts will apply a range of ratios to the figures from their earnings.
Here are some of the most useful financial ratios you can use to measure performance:
Price to earnings ratio (P/E) ratio
P/E compares a stock’s earnings with its EPS. The price/earnings ratio reflects how much you are paying for each pound (or dollar, euro, etc) of a company’s earnings. A high P/E ratio usually means that the markets are expecting large profit growth in the future.
Generally, a P/E ratio of 10-15 represents a reasonably priced stock, but the market has been known to tolerate higher ones – and different sectors will have different average P/Es.
Price/book (P/B) ratio
P/B compares the market’s valuation against its book value per share – or how a company values itself via its financial statements.
The higher the ratio, the more the market is willing to pay for a company above and beyond its tangible assets (e.g. buildings, machinery, inventory).
Return on assets (ROA) ratio
Like the P/E ratio, ROA is a percentage measure – but it evaluates the profit a company is making from its assets.
Return on equity (ROE) ratio
ROE looks at how much profit the company is generating for its shareholders, again expressed as a percentage.
Qualitative fundamental analysis
Up until now, we’ve mostly focused on quantitative fundamentals in this course – that is, data that can be expressed in figures and isn’t based on opinion.
However, stock analysis can also take qualitative fundamentals into account, which can be a lot broader, are often found outside of earnings reports and tend to be a lot more subjective. Examples of qualitative fundamentals might include:
- Leadership. Does the company’s board have a strong history of delivering growth? Share prices will often move on announcements of new CEOs or major changes in leadership, so it pays to do your research
- Patents. Will another player be able to steal your chosen stock’s advantage? Patents can be hugely valuable to companies, so making sure that your stock has exclusive rights to sell its products is key
- Brand. Brand power has kept the likes of The Coca-Cola Company and McDonald’s at the top of stock markets for decades and shouldn’t be overlooked as part of your fundamental analysis.