Your comprehensive guide to understanding the world of stock trading
Fundamental analysis is a method of evaluating a security to determine its intrinsic value by examining related economic, financial, and other qualitative and quantitative factors. Fundamental analysts attempt to study everything that can affect the security's value, including macroeconomic factors (like the overall economy and industry conditions) and company-specific factors (like financial condition and management).
The goal of fundamental analysis is to find securities that are mispriced in the market. If the intrinsic value is higher than the current market price, the security is considered undervalued and a good investment opportunity. If the intrinsic value is lower than the current market price, the security is considered overvalued.
Before analyzing individual companies, fundamental analysts often start with the broader economy. The performance of companies is heavily influenced by economic conditions.
| Indicator | Description | Importance |
|---|---|---|
| Gross Domestic Product (GDP) | Total value of goods and services produced in a country | Measures overall economic health |
| Unemployment Rate | Percentage of labor force that is unemployed | Indicates strength of labor market |
| Inflation Rate | Rate at which prices for goods and services increase | Affects purchasing power and interest rates |
| Interest Rates | Cost of borrowing money | Influences business investment and consumer spending |
| Consumer Confidence Index | Measure of how optimistic consumers are about the economy | Predicts future consumer spending |
| Manufacturing PMI | Purchasing Managers' Index for manufacturing sector | Indicates expansion or contraction in manufacturing |
After analyzing the economy, fundamental analysts study specific industries to identify those that are likely to perform well in the current economic environment. This involves understanding the industry's structure, competitive dynamics, growth prospects, and key success factors.
Industries go through different stages of development, which can affect the performance of companies within them:
Once an industry is selected, analysts focus on individual companies within that industry. This involves examining the company's financial statements, management team, competitive advantages, and growth prospects.
Publicly traded companies are required to release financial statements regularly. These statements provide valuable information about a company's financial health.
Shows a company's revenues, expenses, and profits over a specific period. Key metrics include revenue, cost of goods sold (COGS), gross profit, operating profit, and net income.
Provides a snapshot of a company's financial position at a specific point in time. It includes assets (what the company owns), liabilities (what the company owes), and shareholders' equity.
Shows how changes in the balance sheet and income statement affect cash and cash equivalents. It is divided into operating activities, investing activities, and financing activities.
Financial ratios are used to analyze a company's financial performance and compare it to industry peers. Here are some of the most important financial ratios:
In addition to quantitative analysis, fundamental analysts also consider qualitative factors that can affect a company's value:
Fundamental analysts use various methods to determine the intrinsic value of a company. Some common valuation methods include:
Estimates the present value of a company's future cash flows. This method requires forecasting future cash flows and discounting them back to the present using an appropriate discount rate.
Compares a company to similar companies in the same industry using valuation metrics like P/E ratio, P/B ratio, and EV/EBITDA. This method assumes that similar companies should have similar valuations.
Looks at the valuation multiples paid in recent mergers and acquisitions of similar companies. This method is often used in investment banking for merger and acquisition purposes.
Values a company based on the present value of its future dividend payments. This method is most appropriate for companies that have a consistent dividend payment history.
Suppose Company X has earnings per share (EPS) of $2.00 and is currently trading at $40 per share. Its P/E ratio would be 20 ($40 / $2.00). If the average P/E ratio for similar companies in the industry is 15, Company X may be considered overvalued. However, if Company X has higher growth prospects than its peers, a higher P/E ratio might be justified.