In part two, we’ll dive deeper into investing through stocks. Specifically, we’ll go into detail about how to research stocks and ways to assist you in deciding which stock you should invest in. If you’re new to investing and you are unfamiliar with the various avenues of investment, feel free to take of look a Getting Started with Investing – Part 1. Before you begin looking at companies, it’s best you have a good understanding of how to analyze a stock in order to make an informed investment decision. As a note, although we go into detail about stock analysis, this does not cover everything there is to know, therefore, certain terms and definitions may not be covered in this part.
What is Fundamental Analysis?
Fundamental analysis is a method of measuring the economic value of a stock in an effort to find its intrinsic value by examining its financial factors and other qualitative and quantitative factors as compared to its competitors.
There are two ways to analyze a company in the stock market, fundamental analysis and technical analysis. During this part, we’ll primarily talk about fundamental analysis. Fundamental analysis is often coined as the analysis of WHAT to buy as technical analysis is coined as the analysis of WHEN to buy
Step 1 – Comparing Stocks – Sectors and Industry
Before we deep dive into numbers and ratios, we must first discuss the first step in analyzing a stock. Before you make a choice on which company you will invest in, it is recommended you compare this stock to other similar companies. As I explain the details shortly, the stocks you choose should be grouped by the stock sector/industry and market capitalization. This will help ensure you are looking at stocks in an apples to apples point of view. First, we’ll talk about stock sectors and industries. Each stock is divided into categories of similar type companies. Understanding these categories will help you analyze stock to get a better idea of how the company you choose is performing. Every stock is categorized into 3 categories called Sectors (Defensive, Sensitive, and Cyclical). Within these sectors, they are further divided into categories called industries. This will be your first step to analyzing a stock.
- Defensive – This sector tends to provide stable earnings regardless of the business cycles of the stock market. They are continuously in demand; however, this sector has smaller gains during a bull market.
- Consumer Staple
- Sensitive – This sector has a slight correlation with the cyclical sector and business cycles. This sector may not be impacted as much during a bull and bear market.
- Communication Services
- Technology (Information Technology)
- Cyclical – The cyclical sector is highly sensitive to business cycles and seasons. It can be defined as companies that are closely tied to the ups and downs of the economy. Most of these stocks include companies that sell to consumers. This sector can produce high returns but also have high volatility.
- Basic Materials
- Consumer Cyclical (Discretionary)
- Financial Services
- Real Estate
Its important to understand what sector or industry your stock falls in order to compare your stocks performance to its competitors. In the below picture, from Yahoo finance, Ford Motor Company, after clicking on the profile tab,in the bottom right shows its sector and industry.
Step 2 – Comparing Stock – Understanding Market Capitalization
Investor Pro Tip – Using the earning per share (EPS) ratio is a good way to compare companies despite the size. However, just as the video stated, using this ratio does not account for the individual position each company may be in. Smaller cap stocks may be more volatile and operate with a higher risk than larger-cap stocks which may be more stable and less risky. Understanding these factors will help you make a sound financial judgment.
Step 3 – Fundamental Analysis – Quantitative Analysis
Quantitative analysis, in the stock market, uses one or more of the four financial statements to evaluate a company’s financial data to predict how the company may perform in the future.
- Financial Statements
- Balance Sheet
- Income Statement
- Cash Flow Statement
- Statement of owners’ Equity
Below will cover the two major financial statements needed to get you started in your financial analysis.
Balance Sheet Analysis
- Current Ratio
- Quick Ratio
- Debt to Equity ratio
- Interest Coverage
- Return on Equity
- Return on Assets
- Inventory turnover
- Accounts Receivables Days Outstanding
- Accounts Payable Days Outstanding
Income Statement Analysis
- Net Income Margin
- Gross Margin
- Operating Margin
- Pretax Margin
Qualitative analysis is based on factors that cannot be measured. Below is a list of just a few factors you should weigh before investing in a business. Some of these factors can be found in the company’s annual statement under Management’s Discussion and Analysis.
- What is the companies core business?
- How is the management of the company? High management turnover?
- What is the company’s competitive advantage?
- What is the related risk of the company? (can be found in annual statement)
- What is the industry’s growth trend?
- Disruptive technology and how they can/are fight it.
- What are the political factors surrounding the company?
- Where are they located geographically?
- What industries does this company and its competitors rely on? (Who are the stakeholders?)
- What is the companies market share in their industry?
Limitations of Fundamental Analysis
- Old data – One big drawback to fundamental analysis is the data used. While the financial statements are proof of financial transactions and positions held by the company, this data is not a guarantee of future outcomes. Data presented on the financial statements are simply historical data of the previous quarter(s) or year(s).
- Bad data – Fundamental analysis is based on data reported by management and audited by accounting firms, however, past historical event still prove that despite these preventive measures, data can still be proven incorrect in the long run. While there isn’t a high probability of this happening, the possibility is still there. Accounting scandals have been uncovered causing dramatic stock market changes that have caused investors to lose millions of dollars.
Where to do Fundamental analysis
In final, learning fundamental analysis is a great technique you should use to get started in stock market investing. Remember, fundamental analysis is a skill that the more you use it, the better you will become. When looking to invest in any stock for the long term, understanding the information covered here is essential to ensure you are making a sound investment. As you become more comfortable with this type of analysis, you’ll learn what key ratios you think will work the best and provide the best insights for you. As always, no one ratio should be used alone and the more information you gather the clearer the picture will become.