What Are Fundamentals?
A company’s fundamentals can refer to any figures on information that can help analysts determine the value of a stock or any other type of security. This can include figures relating to a company’s revenue, future growth, earnings, return on equity, profit margins, and any other data that can help one evaluate the underlying value of a company’s future growth potential. While analyzing a company, some investors strictly employ only the fundamental factors or combine it with technicals such as charts, market sentiment, and relative price.
Many traders use the strategy of value investing, which involves identifying undervalued stock, based on fundamental analysis. It means looking at ratios such as price to book, price to earnings, debt-to-equity and price/earnings to growth, etc.
3 Main Sources of Fundamentals
A company’s fundamentals reflect its corporate health and are a necessary ingredient for conducting the fundamental analysis. Before one begins analyzing public companies for their investment potential, traders and investors need to understand some business basics, particularly its financial statements.
Financial statements are the main data points that analysts can use to assess the company’s overall health. It consists of three principal financial statements: Income statement, Balance Sheet, and Cash Flow statements.
- Income Statement: A company’s “take-home” pay is its net income, or in other words, the profit the company receives at the end of the day. The income statement refers to the financial statement that reflects this info. Income statements are profit and loss statement as the net income is either a profit when positive, or a loss when negative. It is generally used by managers for internal accounting and is something investors are interested in. It is the difference between Revenues and Expenses and can be of two basic types: single-steps and multi-step.
- Balance Sheet: One of the most important financial documents used to evaluate the fundamentals of a company is the balance sheet. It is one of the principal corporate financial statements and essentially provides information on a company’s financial state. It consists of two main sectors: On the left side, there are assets; on the right side, liabilities and shareholder’s equity.
Assets consist of anything of financial value which the company owns. The liabilities and shareholder’s equity represent the expenses. Anything that the company owes to creditors, such as bank loans and bond issues, fall under liabilities. The shareholder’s equity consists of retained earnings, which are the income the company holds onto from operations as well as the company’s stocks. The liabilities retained earnings and stock proceeds should balance the assets listed on the other side of the balance sheet.
- Cash Flow Statement: The movement of cash into and out of a company is its cash flow. However, since cash flow is a continuous affair that does not necessarily reflect the revenue, the cash flow statement shows us the actual movement of cash. It reflects the money received or given out for a purpose, such as financing, operating, or investing activities. The cash flow statement divides cash transactions into three different categories: operating, investing, and financing. The total effects of operating, financing, and investing in a company’s cash position is reflected by the net cash flow at the bottom of the cash flow statement.
Financial statements form a key ingredient for conducting the fundamental analysis. However, companies provide investments with an additional wealth of quantities information, besides their financial statements. For instance, the management of a company has a chance to explain their performance by providing the company’s annual report.
How to Understand Performance?
A company’s fundamental performance doesn’t really take the stock price into the equation. Performance, in this case, refers to a company’s efficiency while achieving each of its goals. Based on the results, analysts use the degree of this performance to categorize an investment as either healthy or unhealthy.
One can measure performance in several ways, depending on what metric one looks at. For instance, a company’s earnings, or its ability to generate a profit is a sensible metric to judge a company as a whole. However, one can also use certain metrics for assessing some specific areas of the company, such as using the ROA (return on assets) to check the performance of certain assets. There are several metrics, such as the price to earnings ratio, earnings per share, and gross margin, which one can use to gauge a company’s performance.
One of the main ideas behind conducting fundamental analysis is not to earn some quick capital gains as in the case of day traders. Rather it is aimed at purchasing stock to get the financial benefits via equity. Fundamental analysis involves value stock investing. It strives to find companies whose intrinsic value is already more or is expected to overtake its market value.
However, one should realize that simply looking at the stock price is not enough while measuring performance. Other key factors to look at include expectations or estimates put forward by analysts as well as any positive or negative trends in the financial statements.
Compare Similar Stocks
When investors compare the performance of different stocks in the market, it is important to note that these comparisons are not fool-proof. For instance, if we compare stocks of U.S. Steel with Google, which is a technology company, we will find that the latter company’s price-earnings ratio is four times that of the former. A lower price-earnings ratio (P/E) can indicate more profitable investment. However, in this case, U.S. Steel is in the basic materials sector, and one cannot compare the P/E of this sector with that of the technology sector. Hence, in such cases, investors should compare companies in similar industries or in the same sector or industry.
For example, eBay’s stocks are comparable to Amazon.com or Alibaba, while stocks of the Bank of New York are comparable with that of JP Morgan Chase or Bank of America.