Top 6 Fundamental Analysis Tools to Know
Warren Buffett, Peter Lynch, and Benjamin Graham.
We all know the names. But what is it they all have in common?
Well, besides the fact they all became obscenely wealthy, not one of them ever used technical analysis to trade their stocks along the way. Instead, they all relied solely on fundamental analysis to build their famous fortunes.
But just what is fundamental analysis? In short, it's the use of the actual nuts and bolts of a company to arrive at stock's intrinsic value. Using it, we can understand a company’s:
- Competitive advantage
- Earnings growth
- Sales revenue growth
- Market share
- Quality of the company's management
Then again, there’s never just one way to analyze a stock.
But when it comes to long-term investing, one of the best ways is with fundamental analysis.
Any successful investor will tell you that. Just look at Warren Buffett for example.
In 1988, after studying the nuts and bolts of Coca Cola (KO), he bought more than a billion dollars worth of stock. That’s because he saw consistent performance, good long-term prospects, and a bargain in the stock price after years of disaster. The stock, said Buffett, wasn’t reflective of the growth set to occur in the company’s international business.
Shortly after, he would make a fortune, as Coke exploded.
Even today, we can find the same potential by asking these simple fundamental questions:
- Are company earnings strong and sustainable, or weak?
- Is the stock overvalued / undervalued based on its price to earning ratio?
- Is it trading at or below future growth, per its price to earnings growth ratio (PEG)?
- Is the company making a profit?
- How does the stock trade in comparison to overall sales?
- Where does the company stand with regards to competition?
When it comes to this analysis, it’s all about earnings.
How much is the company making now? How much could it make in the future?
Some of the key building blocks to understanding how to value a stock can be found with price to earnings, profit margins, return on equity (ROE), price to earnings (P/E), Price to Book (P/B), as well as PEG ratios.
Let’s start with earnings.
Earnings are the bottom line. It’s the lifeblood of any company, if you will.
Before investing in any company – especially for the long-term – you must know how much the company is earning. Is it even profitable? Or is it bleeding cash? If the latter, why is that happening? When does it expect to turn things around?
If you don’t know, why are you buying it at all?
Future earnings are also a key factor for a look into the future of the business and potential growth opportunities. Be aware of this. Factors determining earnings are things such as sales, costs, assets, and liabilities, which we can see through EPS, or Earnings per Share.
Earnings don't always tell the full story. The profit margin will tell us how much the company is keeping in earnings for every dollar of revenue. The higher the profit margin, the more control it may have as compared to its competition, for example.
Price to earnings growth (PEG)
Any PEG ratio greater than 1.0 tells an analyst the stock may be overvalued. A read under 1.0 may be a strong indication of undervaluation. It’s not always a reliable indicator, though. It’s typically based on projected EPS. And, as we all know, projections aren’t always accurate.
Return on Equity (ROE)
ROE refers to profit generated in comparison to book value. This is calculated by dividing after-tax income by its book value. It lets us know a few things such as debt of the company, revenue and what value is being returned to shareholders.
Price to book (P/B)
Price to book allows an analyst to unearth undervalued opportunities. It’s the ratio of the market price over its book value, or the value of assets on the balance sheet. Lets say stock ABC has $200 million in assets on its balance sheet and $80 million in liabilities.
Book value would be $120 million. If we also have 20 million shares outstanding, each share of ABC would carry book value of $6 a share. If ABC then traded at $3 a share, the P/B ratio would be 2.0. This ratio helps an analyst identify lower priced stocks being discounted by the overall market.
Price to Earnings (P/E)
While this is not the Holy Grail that some investors think it is, P/E does give you a window into how the market values a security. For instance, if a stock is priced at $50 per share and it has an EPS of $5 per share, it has a P/E ratio of 10. The higher the P/E, the more the market is willing to pay for each dollar of annual earnings.
Of course, companies that don't have earnings have no P/E ratio at all — which is why you'll rarely find a fundamental analyst anywhere near them.
These are just some of the key fundamental tools to know.