Fundamental analysis is the method of evaluating a stock by examining the underlying business. Instead of looking at price charts, fundamental analysts study financial statements, competitive advantages, and growth prospects to determine what a stock is truly worth.
What is Fundamental Analysis?
Fundamental analysis answers one key question: Is this stock worth more or less than its current price? By analyzing a company's financial health, earnings power, and competitive position, you can estimate its intrinsic value and make informed investment decisions.
Key concept: Intrinsic value is what a stock is actually worth based on the company's fundamentals. If the market price is below intrinsic value, the stock may be undervalued - a potential buying opportunity.
Fundamental vs Technical Analysis
These two approaches answer different questions:
- Fundamental analysis: What should this stock be worth? (The "what")
- Technical analysis: When should I buy or sell? (The "when")
Many successful investors use both - fundamentals to select quality companies and technicals to time their entries and exits.
The Three Financial Statements
Fundamental analysis starts with understanding three key financial documents:
1. Income Statement
Shows profitability over a period (quarterly or annually):
- Revenue: Total sales the company generates
- Gross Profit: Revenue minus cost of goods sold
- Operating Income: Profit from core business operations
- Net Income: Bottom line profit after all expenses and taxes
2. Balance Sheet
A snapshot of what the company owns and owes:
- Assets: Cash, inventory, property, equipment
- Liabilities: Debt, accounts payable, obligations
- Shareholders' Equity: Assets minus liabilities (book value)
3. Cash Flow Statement
Tracks actual cash moving in and out:
- Operating Cash Flow: Cash from core business activities
- Investing Cash Flow: Capital expenditures and investments
- Financing Cash Flow: Debt, dividends, share buybacks
Key Valuation Metrics
Here are the essential ratios every fundamental analyst should know:
Price-to-Earnings (P/E) Ratio
The most common valuation metric. It tells you how much investors pay for each dollar of earnings.
Formula: P/E = Stock Price / Earnings Per Share
Example: If Apple trades at $150 and earns $6 per share, its P/E is 25. This means investors pay $25 for every $1 of earnings.
- Lower P/E may indicate undervaluation (or problems)
- Higher P/E may indicate growth expectations (or overvaluation)
- Compare P/E to industry peers and historical averages
Price-to-Book (P/B) Ratio
Compares market value to accounting value.
Formula: P/B = Stock Price / Book Value Per Share
Example: A stock trading at $50 with book value of $25 per share has a P/B of 2.0.
Price-to-Sales (P/S) Ratio
Useful for companies without consistent profits.
Formula: P/S = Market Cap / Annual Revenue
Example: A company with $10 billion market cap and $5 billion revenue has a P/S of 2.0.
PEG Ratio
Adjusts P/E for growth rate - a more complete picture.
Formula: PEG = P/E Ratio / Earnings Growth Rate
Example: A stock with P/E of 30 growing earnings at 30% annually has a PEG of 1.0. Generally, PEG below 1 may indicate undervaluation.
Profitability Metrics
Return on Equity (ROE)
Measures how efficiently a company uses shareholder money to generate profits.
Formula: ROE = Net Income / Shareholders' Equity
Example: If a company earns $10 million with $50 million in equity, ROE is 20%. Higher ROE typically indicates better management and competitive advantages.
Profit Margins
- Gross Margin: (Gross Profit / Revenue) - Shows pricing power
- Operating Margin: (Operating Income / Revenue) - Shows operational efficiency
- Net Margin: (Net Income / Revenue) - Shows overall profitability
Financial Health Metrics
Debt-to-Equity Ratio
Shows how much debt the company uses relative to equity.
Formula: D/E = Total Debt / Shareholders' Equity
Example: A company with $100 million debt and $200 million equity has D/E of 0.5. Lower is generally safer, but some industries naturally carry more debt.
Current Ratio
Measures ability to pay short-term obligations.
Formula: Current Ratio = Current Assets / Current Liabilities
A ratio above 1.5 typically indicates good short-term financial health.
Free Cash Flow
Cash available after maintaining and expanding operations.
Formula: FCF = Operating Cash Flow - Capital Expenditures
Positive and growing free cash flow is a strong indicator of financial health.
Qualitative Factors
Numbers do not tell the whole story. Also consider:
- Competitive Moat: What protects the company from competitors? (Brand, patents, network effects, switching costs)
- Management Quality: Track record, capital allocation, insider ownership
- Industry Trends: Is the industry growing or declining?
- Regulatory Environment: Are there risks from government action?
Putting It All Together: A Simple Framework
When analyzing a stock, follow this checklist:
- Understand the Business: What does the company do? How does it make money?
- Check Financial Health: Is the balance sheet strong? Manageable debt?
- Analyze Profitability: Are margins stable or improving? Good ROE?
- Evaluate Cash Flow: Does the company generate real cash?
- Assess Valuation: Is the stock cheap or expensive relative to fundamentals?
- Consider Growth: What is the growth outlook? Is it sustainable?
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Common Mistakes to Avoid
- Focusing on one metric: No single ratio tells the whole story
- Ignoring debt: High debt can sink even profitable companies
- Chasing growth without value: Growth at any price is dangerous
- Neglecting cash flow: Earnings can be manipulated, cash is real
- Not comparing to peers: Valuation is relative to industry
Summary
Fundamental analysis helps you understand what a stock is truly worth by examining the underlying business. Key components include analyzing financial statements, calculating valuation ratios like P/E and P/B, evaluating profitability metrics like ROE, and assessing financial health through debt and cash flow analysis. Combined with qualitative factors like competitive moats and management quality, fundamental analysis provides a framework for making informed investment decisions.
Learn more: how to read a balance sheet, income statement guide, and return on equity explained.