Economists like talking in jargon. One of their favourite but confusing terms is to talk about stock fundamentals as if everyone knows what they are.
But what are stock fundamentals, and how do they help investors choose shares?
The fundamentals are generally considered to cover any vague data that might impact a stock’s price.
For investors, the fundamentals cover the analysis of key metrics, like a firm’s cash flow, return on investment and gearing.
The analysis takes the fun out of fundamentals, as trawling through a corporation’s financial accounts and other financial data is a gruelling task.
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Scrutinising Stock Fundamentals
In general terms, examining stock fundamentals involves analysing any data which could affect a company’s share price.
Fundamental analysis is a broad snapshot of how a business has performed to a set date designed to confirm the value of the company’s shares and whether to buy, hold or sell shares based on the data.
Each investor will have their list of fundamentals to analyse, but most will cover these main indicators:
- Return on assets
- Gearing
- Cash flow
- How profits are reinvested
- How the board manages the company to maximise shareholder returns
Fundamental analysis will also benchmark the company’s performance against competitors and estimate growth potential.
How To Carry Out Fundamental Analysis
To carry out fundamental analysis, you don’t have to be a corporate ninja. All the information you need to address is free and mostly online.
The primary data source is the company’s financial statements, while accounting ratios are the main tools for the investigation.
The aim is to pore over the data to confirm if the company’s shares are accurately priced and to forecast any growth potential.
Investors embarking on a fundamental analysis of a company’s share ignore the ticket price on the stock as unreliable. That’s because stock prices can rise and fall without notice without considering the market value of a company and its products.
Instead, the analysis strips the value to the barebones to establish the book value of the company once the hype is spun away.
A fundamental analyst will look at the quality of the product, check consumer reports to establish how the public perceives the company and stress-test the company’s balance sheet to prove financial stability.
At the end of the analysis, a report suggests the company’s intrinsic value to an investor.
The investor green lights buying or holding a share in the company if the intrinsic value set by the analysis is lower than the intrinsic value.
If the analysis sets the stock price above the intrinsic value, the investor sells the stock or awaits a fall in the price before buying more stock.
Remember, despite all the work involved in fundamental analysis, the results are not a guarantee stock is under or overpriced.
A Fundamental Flaw
Sifting through piles of paperwork to perform a fundamental analysis is hard work.
However, some investors rub their hands with glee when analysing fundamentals because they know the result could land them a significant profit or avoid a hefty loss if they pinpoint the price of a stock is wrong.
So, now you know what a market analyst means when they say a stock is over or undervalued.
But there is a flaw in analysing stock fundamentals.
No matter how thorough the analysis, there is no recognised formula for setting a company’s intrinsic value. Many investors delving into a stock’s price believe they are picking winners by checking out the fundamentals in a rising market. The reality is picking winners in a bullish market is not hard.
A stock picker’s real talent delivers winners when the market is in a trough.
Settling on an accurate intrinsic value comes from experience and understanding the market.
What’s Best, Fundamental Or Technical Analysis?
Fundamental and technical analyses are the chalk and cheese of investing.
Fundamental analysis zeroes in on discovering the intrinsic value of a stock.
Technical analysis looks at the pricing and trading history of a stock to establish where the value might go in the future.
Whereas fundamental analysis looks at what drives a stock’s value, technical analysts seek to analyse patterns and trends in trading to look out for in the future in the hope a stock will repeat past performance.
However, in truth, neither methods are foolproof when predicting how a stock will perform, but carrying out analysis gives an investor a better idea of how a stock will perform and is better than sticking a pin into a list of companies.
How Do Accountancy Ratios Work?
Investors look for undervalued companies with investment potential to make a profit.
Ratio analysis looks at four factors – profitability, liquidity, solvency and value.
The ratios are useful for benchmarking performance as they apply a standard analysis across the board and are the bread-and-butter of fundamental analysis.
The most common ratios are price-to-earnings (P\E), net profit margin and debt-to-equity (D\E)
Profit ratios indicate how much profit a company makes and how profits relate to other financial data.
Liquidity is about how a company’s assets cover spending and how rapidly debts are repaid.
Solvency or leverage ratios test how much debt a company is carrying.
Valuation ratios take a view of the price of the company’s stock and how the cost rates against other companies serving the same sector.
Fundamental Analysis FAQ
Why do investors use ratios?
Ratios are a great way of benchmarking a company’s financial performance. Because the same ratios are applied to each company, it’s easy to compare track records. Ratios can also show how a company has traded over time.
Should I carry out a fundamental analysis before trading stock?
It’s a good idea to have some information about the shares you are trading. Otherwise, you cannot make an informed decision about the investment.
How do I analyse a stock?
You want to collect the company’s financial statements for the past three years. Set up a spreadsheet template to automate the process as many ratios operate on the same data, then input the figures from the financial statements into your worksheets. The tricky bit is interpreting the results, although accounting textbooks guide investors on how to read the answers.
Can I download a guide to the ratios?
Suppose you have a basic understanding of how a spreadsheet works. In that case, you can easily link a sheet listing financial data with another sheet automating the ratios, which are mainly simple maths formulas.
Ready-made templates are available for Google Sheets or Microsoft Excel through their online stores.
Alternatively, book-keeping guides will give examples and explain how the ratios work.
What’s the acid test?
The acid test is also called the quick ratio. The formula indicates if a company has enough ready assets to pay bills. Despite the name, the ratio is not always the most reliable way of assessing a company.
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