Fundamental Analysis of Stocks

Simply stating, fundamental analysis of stock is the process of analyzing a business on a fundamental and financial level. It involves analyzing the security or business by going through its financial statements a health, market competition and management’s effectiveness. It analyzes everything which could affect the security price which includes macro economic factors like overall industry and economic conditions as well as specific condition of the business.

The main aim of doing fundamental analysis is to be able to decide whether it is a good idea to buy a security, hold it or sell it based on its current price. Using fundamental analysis, this type of decision can be made. This type of valuation can be done for stocks as well as any other type of security like forex, options etc.

Fundamental analysis of stock is done on current as well as historical data with the hope of predicting the financial forecasts of a company. Fundamental analysis of stock can be done to answer questions about a company like:

• Is the company’s revenue growing or not?
• Is the company making any profit?
• Will it be able to survive competition and beat it?
• Will it be able to repay its debts?
• Is the management effectively running the business or is it cooking books?
• What is the credit risk of the company?
• And many more…

As mentioned in stock analysis for beginners, fundamental analysis is done based on a few factors like value, growth, GARP, income and quality. Let’s take a look at these factors.

The main purpose of choosing one stock over others is the intrinsic value of that stock. All investors would like to know the value of stock so that they know what profits they will get in case they sell it tomorrow. But, determining value is not a straight forward task. Beginners should understand that although most value investors believe in certain things, not all who use the word “value” mean the same thing.

Growth investing is done by those who think that the company will grow in future at a reasonable pace. Growth is very frequently linked with relatively new companies which have the potential to grow faster than already established ones.

Many people invest not just for value, nor do they look for future growth of the company. They simply invest in a stock because it has a good history of giving out dividends. These types of investors are called income investors.

GARP (Growth at reasonable price) is another concept used by practitioners believing in fundamental analysis of stock. This is basically a combination of value and growth theories and then it puts an additional numerical slant to the equation. One of the common GARP approaches is to buy stocks when the P/E ratio is lower than the rate at which earnings per share can grow in the future. Since GARP uses numbers in its equation, some people believe that it is a part of quantitative analysis instead of fundamental analysis.

Quality – People who want a real quality stock look at all the above factors – growth, value, GARP and income to decide upon a high quality stock. In this theory, fundamentals like management competitiveness along with numerical figures like return on equity (ROE) are looked at in totality. The qualitative and quantitative factors are looked in conjunction to find the real quality stock.

Fundamental Analysis Tools

There are various tools or financial ratios which are used to do fundamental analysis. Some of them are:

1. Earnings per Share – EPS
2. Price to Earnings Ratio – P/E
3. Projected Earning Growth – PEG
4. Price to Sales – P/S
5. Price to Book – P/B
6. Dividend Payout Ratio
7. Dividend Yield
8. Book Value
9. Return on Equity

Criticism of fundamental analysis technique

There are mainly two arguments against fundamental analysis of stocks. One argument is that this analysis is done based on public information which is known by all. Since it is public information, there is no advantage which can be taken by one analyst over another