Fundamental Stock Analysis
A practical guide to conducting your first basic stock analysis
As a first step into understanding an investment, Fundamental company analysis attempts to look at a business on its’ most basic level, both financially and also from a general perspective. It usually involves looking at several simple factors and metrics in order to finally answer the question: “Is the company I am looking at, currently fairly valued? Or is it under-/overvalued?” In simpler terms, you could also refer to it as “getting to know the company” you are looking at.
What to do?
The process itself can start by either reading up recent news, having a look at some of the key metrics or heading to the companies homepage. The main points to investigate during the analysis should focus on both, the company itself as well as the environment/industry in which it operates, such as:
What is this companies’ business and how are they generating revenues?
What kind of market are they operating in?
Are they profitable?
Who are the competitors and does my company have an advantage?
How are other companies in this sector valued?
Who is managing the company and how are they incentivized?
The list could probably be continued endlessly, but to develop a basic understanding of a stock as well as how the company behind it is operating, you should focus on these main factors before diving deeper into the numbers, reports or available analyses. And dive deeper, you should, as I explain a little below. Before that let’s quickly return on how to best answer the above questions.
There is no right and wrong in how you want to go ahead with your own analysis. You can head over to finviz.com and check key figures or recent news on the stock you want to analyze. You can go ahead and have a look on the overall industry/sector in which you ponder an investment (maybe outlooks are so bad that you decide it’s not the right one for you).
Visit the homepage…
What I like to do usually, is start right on the companies’ website. If you have no idea what they are about, go ahead to the “About” section to see how they assess themselves.
Afterwards, try and see if you can find any recent corporate presentations inside the “Investor Relations” section. Good companies always have one and keep them updated regularly with their latest financials as well as incorporating and communicating any important changes. Inside you should find information not only about recent financial results, but also things like mid- to long-term targets or current global/macro economical difficulties might be highlighted.
…to check the reports and financials
If you can’t find anything, are not too interested in qualitative targets or are more of a number guy that’s not a problem at all, you might just as well head directly into the latest financial report or earnings release presentation. Most companies will either upload their 10K or 10Q (as filed with the SEC) as it is or might create a separate presentation format to make it easier to read. Here, you might as well start looking for things like:
Is the business profitable?
What “segments” is the company operating in?
Are revenues (and by extension also net income) growing?
What is the outlook for the current year?
You will find the managements comments on recent development and reading their statements can get you some feeling on how they view the company and assess the current situation. You may even find information on the overall market or macro developments that may (or may not) affect the company in the future, in the best case already accompanied by a few sentences detailing how management plans to cope with them. Scroll down to the Income Statement to check whether “Net income” is positive, which means the company is earning money! Is it higher than last year? Even better.
If you know your way around, go ahead and dig a little deeper to check if they also generate a positive cash flow! This will come in handy when the company wants to return money to its’ investors (you?!).
Check and compare key performance indicators
Read up yet? Then let’s head back to finviz.com (or the likes of bloomberg, yahoo finance, FT or others if your looking up European or other stocks). Now it’s time to get a feeling of the companies’ current valuation in the market as well as comparing it to its’ peers.
If you had a look at the companies latest reporting you probably already have some idea about their financial situation. Nevertheless, have a first look at the P/E ratio. It compares the current stock (P)rice to the (E)arnings the company achieves per share (more on the ratio itself and other comparison multiples will come in a future post). As the most popular comparative indicator, it is readily available on most websites it can provide you with an almost instant option to compare your stock to other stocks. If the company is not turning a profit yet, don’t worry about the P/E ratio and use the P/S (as in (S)ales) ratio instead.
If you have identified one (or some) of the competitors already, go and make a comparison, keeping in mind that the lower the better goes for both of these metrics.
If you do not yet know who might be competing for a “piece of the cake” in this specific industry, go ahead and use your stock screener for a sector search in order to find them (see above).
In case you are not too eager to head to the companies homepage and read reports, you will find enough aggregated information here on the stock screening website of your choice to get a first feeling about the stock you are looking at. Check if sales have increased in the last year, or better the last 5 years. Continuous growth over the past 5 years might indicate that there is further room to grow also in the future.
How is the company financing their (hopefully) increasing business? Are they growing “organically”, meaning they can finance additional investments from their own cash flow? Here you could check and compare Debt-to-Equity ratio, which indicates if the company is using more borrowed money (if >1), or its’ own (if <1). You can also do another comparison here, checking the P/(C)ash ratio to that of the competitors.
Go deeper (as far as you’d like)
You should by now already have some feeling about what the company does, how their business works and whether they are profitable, as well as how they fare against their main competitors in terms of valuation. You have therefore uncovered the basics (or fundamentals), congratulations!
From here on it is up to you on how much further you want to investigate this specific business. Maybe you’d like to know about the future development of the sector itself?! Maybe everything looks too good to be true and you wonder about risks that might be less obvious?! There is an answer to most of these questions. Ask them and then try to find the solution through a little bit of research (often a little google search or reading recent news give surprising results)!
Fundamental analysis attempts to answer the question whether a specific stock (or more general investment) is currently valued correctly (“fair”)
There is no right and wrong way; think of a few questions that you yourself want answered before starting the process as it will help you find conviction
Reading company presentations and/or financial reports can provide not only quantitative but also a lot of qualitative information to your assessment
Comparing the basic Key Performance Indicators like the P/E ratio, P/S ratio, Debt/Equity ratio etc. to that of it’s peers, is a simple but effective way of ranking a companies current market value
You are free to investigate as much as you want!
With algorithmic trading nowadays making up the bulk of daily trading volume on most exchanges (the equity/stock market in particular), it has become more or less impossible to gain an advantage solely from looking at (especially) the most popular financial indicators. A low P/E ratio no longer indicates that the business at hand is undervalued with 100% certainty. Same goes for other common indicators, like the Debt/Equity ratio, P/B ratio, just to name a few. As information becomes available instantly and trades are executed automatically just seconds after, any changes in the anticipated future value of a stock, will immediately be reflected in the share price.
In order to find a “safe bet” I can therefore not stress enough the importance qualitative research in order to gain an advantage in today’s market. It will help not only your understanding of the company you want to invest in, but also increase your conviction in deciding whether to go ahead or move on to another opportunity.
Whether it is a scoring system like mine (I will introduce it in an upcoming post), a detailed industry analysis or a scenario based company valuation. After some time you will get a feeling on whatever works best for you!
What DOES work for you?
Let me know how you approach a stock evaluation in the comments!