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Learning the Fundamentals of Stock Analysis

16 Feb 2022

Fundamentals of Stock Analysis | VI


One of the things that make stock investing sound intimidating is stock analysis. Yes, you know it’s important to evaluate a stock as if you’re assessing a business, but how exactly do you do that? What must you look for? What should be the benchmark?

Stock analysis may be done in different ways, depending on your purpose. The most popular analyses you’ve probably heard about are fundamental analysis and technical analysis.

As our value investing community seeks to invest in stocks with a long-term outlook, we will focus on fundamental analysis in this article, although we’ll also give you an overview of how it differs from technical analysis.

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Fundamental stock analysis

You sure know that in stock investing, we typically look at two things: price and value. But you must also be aware that the stock’s price doesn’t always reflect its true value. It could be priced higher than what its intrinsic value is or it can be priced lower than what it’s truly worth.

This is where fundamental analysis comes in. Value investors analyse the stock’s fundamentals before making any decision as they want to invest in fair valued, if not undervalued, companies. Hence, just looking at the price won’t be sufficient, and a deeper analysis is needed.

Therefore, fundamental analysis is essentially the process of looking at a company's fundamentals to estimate a stock's "true value."

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We use it to assess a stock that we believe is undervalued by the market, and is, therefore, a good investment opportunity for us, as strong fundamentals would give us a strong warrant that its price would rise over time. Similarly, looking at a stock’s fundamentals can help us decide when to sell an overvalued stock.

Fundamental vs technical analysis

As we have established above, fundamental analysis primarily looks at the stock’s value vis-à-vis its price. Technical analysis differs as it looks at the price trends and patterns rather than the stock’s value and fundamentals.

If you’re doing technical analysis, you depend on the price and volume movements of stocks. This type of analysis, instead of checking the stock’s valuation and other metrics that we’ll discuss below, uses charts and other tools.

Usually, technical analysis is practised by traders who are on the lookout for stocks that they believe follow a certain price trend. Hence, it’s more applicable for short-term investors.

Value investors often do away with just relying on technical analysis, as the market most of the time doesn’t accurately reflect a stock’s value.

A stock's fundamentals

A stock's fundamentals | VI

So how then do you do a fundamental analysis? Or to rephrase the question: What are the fundamentals of a stock that you should look at?

Quantitative and qualitative factors make up a stock’s fundamentals. These are factors that will guide you in determining the company's value. We will go through these factors and how you can evaluate each.

Quantitative factors

Valuation is calculated using different methods. Each method works for specific types of companies and uses various quantitative data. Don’t worry, these data are publicly available for your analysis.

Below are some of the most frequently used quantitative measurements in fundamental stock analysis.

Earnings per share

When you want to check if a company has growth potential, the first thing you look at is whether or not it is profitable. Consistently positive and growing earnings per share (EPS) is a good measure of a stock’s profitability, along with other factors such as net and gross profit margins, revenue, and income.

When we say revenue, we refer to the income that comes from the sale of products and services. The figure we get after deducting all the costs and expenses from the revenue is called the net income. And this is where EPS enters the equation.

EPS is the income that belongs to each share. Hence, it is calculated by taking the net income divided by the number of shares. If a company’s EPS in the past five years is consistently growing, it often is a good determinant that the stock could be profitable.

Price to earnings ratio

Price to earnings (P/E) is related to EPS. It is a comparison between the current price of a company's stock to its EPS.

Hence, you can think of it as simply the price investors pay for one dollar of earnings per year.

Debt to equity ratio

We all know that debts can be detrimental to our future. It’s the same with stocks. If a company has massive debts, would you invest your money in it? We don’t think so.

The debt to equity ratio (D/E) determines the extent to which a company's operations are funded internally and externally. It compares a company's debt to its shareholder equity. Or in other words, D/E is a measure of whether or not the company has the ability to pay off its debts.

To calculate the D/E, you can divide the company’s total debt or liabilities by the total equity. Ideally, the result must be less than 0.5, if not zero. As much as possible, prioritise companies that are conservative in terms of borrowing money.

Free cash flow

You wouldn’t want to invest in a company without a proven ability to make and collect money, would you?

Free cash flow (FCF) is calculated by deducting the cost of capital expenditures from the cash from operations. And we want to see a positive and growing FCF in a company that we’ll invest in. This is because a consistently positive FCF would also allow the company to pay dividends to shareholders, reduce their loans, do research and development for new products, or save money.

Return on equity

Part of evaluating a stock is looking at the efficiency of its underlying company. You can review the efficiency by using the return on equity (ROE) metric.

When we say equity, we mean the business’s net worth, and this belongs to the shareholders. Whenever the company generates profits, it can opt to distribute the profits as dividends or just retain them as equity. Hence, as a shareholder, you have to check whether the company is making good use of the retained profit.

To calculate ROE, you must divide the net profit by the total equity. Oftentimes, a consistent result of more than 15% equity is a good sign.

Dividend payout ratio

The dividend payout ratio applies if you intend to invest in dividend stocks. This will be a significant measure of whether or not the dividends the company gives out to shareholders will be satisfactory for your investment objectives.

Basically, the dividend payout ratio is the percentage of income that the company pays out in dividends to shareholders. You can calculate the dividend payout ratio by dividing the total amount of dividends paid to shareholders by the company’s net income.

All these quantitative factors are made publicly available for investors. All you need to do is check the company’s website and look for the financial reports. Typically, you can find these numbers in the income statement, balance sheet, and cash flow statement.

If you want an easier way to find and analyse all these factors, go to the VI App and all these key ratios will be made available to you in seconds.

Qualitative factors

Stock's Fundamentals | Qualitative Factors | VI

While quantitative measures are crucial because they provide investors with a common way to evaluate companies in the same sector, fundamentals are more than simply numbers.

Less measurable but equally important factors must be addressed when assessing a company's fundamentals. A handful of the most important is listed below.

Business model

The strategy through which a company makes money is referred to as its business model.

For example, Microsoft’s business model is focused on personal computing, cloud services, and productivity processes. Coca-Cola's business model, however, is focused on selling beverages.

To understand a company’s business model, you ought to ask this question: How does the company make money?

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Checking the business model of a stock you’re investing in is crucial to further investigate whether or not the company can survive in the long term. You wouldn’t want to invest in a company whose business model will only last for the next couple of years unless you don’t want to profit from your investments.

Competitive advantage

Investing in companies that have a certain competitive advantage is a no-brainer. This is related to understanding the business model, as the advantage that a company enjoys often determines whether or not it can thrive for the long term amidst the fast-changing world we’re living in.

There are several types of competitive advantages (or some prefer to call these “economic moat”) that a company can have. For instance, Microsoft enjoys an advantage wherein it’s difficult for customers to switch to another application as it will costly and hence irrational. Nestle, on the other hand, has a cost advantage due to it being an established and a large company, thereby, it can drive costs down and lower prices.

Management

Looking at the company’s management is often a step investors take for granted, not knowing that this is crucial to the business’s future.

The management consists of people who are the key decision-makers of the business. Hence, they are the ones who will steer the boat forward. And if they aren’t competent enough, the boat will remain stuck, or it could sink anytime.

All these quantitative and qualitative factors must be taken into account in your fundamental analysis. Yes, it might look like a tough job, but it’s certainly critical for your investing success.

Think of looking at a stock’s fundamentals as choosing where to send your child to learn. You won’t just settle for the one that has the cheapest fees or the biggest student population. You would want to send them to the best school. And to do that, you need to check the school’s management, licences, reviews, security, curricula, teaching personnel, fees, and other factors.

If you want to learn how to analyse stocks in a smarter, faster, and easier way, feel free to join our complimentary masterclass.

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