There are many schools of thought as to how an investor should intelligently choose the companies and stocks he will invest in. Some believe in fundamental analysis as the best way to go about this. Others rely on technical analysis of historical volume and price movements as represented by charts. Still, there are those who promote a combination of the two.
In this post, we’ll look at fundamental analysis as a basis for picking stocks.
In a way, the fundamental investor, will take the viewpoint of someone buying into the business – as if he will actually be a owning a majority of the company. Someone in such a position would usually be investing for the long haul. Warren Buffet, for instance, is often quoted as saying that he buys a stock based on the assumption that the stock market will close the next day and not reopen for another five years. He also says that if you aren’t willing to hold a stock for ten years, you shouldn’t even think about owning it for ten minutes. If you want to follow Warren Buffet’s advice, then you need to do fundamental analysis on the stock you plan to buy.
Aside from long-term investors, value investors also need to apply fundamental analysis. The value investor believes that the market price does not always reflect a company’s true or intrinsic value. Market price frequently fluctuates – daily and even by the second at times. But the real value of the stock is relatively stable. So the value investor looks for price points where the market price falls far below the real value of a stock – and buys at such discount prices. He uses fundamental analysis to determine the real value – analyzing the financial statements published by a business quarterly and annually, also looking at financial projections based on revenue and cost data.
To do basic fundamental analysis you need the following Financial Statements, which are publicly available for all listed companies:
- Statement of Comprehensive Income or Income Statement
- Statement of Financial Position or Balance Sheet
- Statement of Changes in Equity
- Statement of Cash Flows
From these Financial Statements, you need to get the following data:
- Net Income (which can be found near the bottom part of the Income Statement)
- Revenue (which can be found near the top part of the Income Statement)
- Stockholders’ Equity (which is located near the bottom of the Statement of Changes in Equity)
- Outstanding Shares of Stock (which may be found in the Statement of Changes in Equity or in the Notes to the Financial Statements)
Equipped with the above data, you can then compute for the following financial ratios:
- Earnings per share (EPS) – compute this by dividing Net Income by Outstanding Shares of Stock. As a fundamental investor, you are concerned if the business is making money or not. So you look at the Net Income. By dividing Net Income by the number of outstanding shares, you convert the total Net Income figure on a per share basis. Thus you can compare different sized companies’ apples to apples just by comparing their EPS. The higher the EPS, the better.
- Profit margin– compute this by dividing Net Income by Revenue. Revenue is what a company gets paid for its products or services. Once you subtract from Revenue the costs that were incurred by the company, you get the Net Income. Profit margin shows how a company controls its costs. Assume two companies in the same industry. Company A has a net income of $1000. Company B has net income of $500. But then, Company had to earn revenues of $10,000 so it could earn the $1,000 net income. Meanwhile, Company B only needed revenues of $2000 to end up with the $500 net income. Company A has a profit margin of 10% while Company B has profit margin of 50%. Company B has better cost control and it is reflected in the higher profit margin. The higher the profit margin, the better.
- Return on equity (ROE)– compute this by dividing Net Income by Stockholders’ Equity. This ratio shows how effective a company is in generating profits using the capital it has. When comparing the ROE of two companies, the one with higher ROE made more profits out of the same capital invested or made the same profits out of less capital invested by the owners or stockholders. So the higher the ROE, the better.
- Price to earnings (P/E)– compute this by dividing the Market Price by Earnings Per Share. This ratio is used to compare companies within the same industry, especially since benchmark PE ratios differ from industry to industry. The higher the PE, the more expensive the stock. PE ratio basically means, how much an investor has to pay for the earnings of a share of stock. Comparing the PE ratio to the industry standard will help you determined if a stock is overvalued or undervalued.
Equipped with these simple ratios, you can already do basic fundamental analysis on any company you are considering for investment.