Fundamental Analysis and Choosing Stocks
Many investors look at a term like “fundamental analysis” and think “That’s for those day traders and people who pick their own stocks. I don’t have time for that. And besides, I could never understand all that financial stuff.”
For that reason, many investors rely on advisors to make recommendations on the individual securities or mutual funds that become part of their investment portfolio. The thinking is that these advisors are the experts, so why should you try to out-think them? Some of that may be true. We can’t all be experts at everything. However, consider this statement.
It’s your money.
Sometimes in the routine of our day-to-day life, our investments can just be another thing “over there.” We don’t pay attention to the fact that it’s our money that’s at risk every day. And here’s another thought:
You’re a part owner of the companies you invest in.
Wouldn’t you want to know how well they’re doing? Wouldn’t it be important to analyze their business to see if they are a wise investment now and in the future?
It’s funny, really. We know we’ll never own a professional football team, yet we can spend hours every week to keep tabs on our favorite NFL team or manage our fantasy football team. We’ll never produce a movie, but we know the names and career histories of dozens of actors. Yet when it comes to our investments, we think it’s too complex and we’re content to let others do it for us.
In this article, we’ll help you understand what fundamental analysis is, why it’s important for you as an investor, what fundamentals you should be looking for in a stock, and how to do your own analysis.
What is fundamental analysis?
In its simplest form, fundamental analysis is a way of anticipating the value of a stock by studying the balance sheet, earnings, management, product lines and other elements of a company’s stock. Practitioners of fundamental analysis are attempting to answer these and other questions:
- How profitable is the company?
- What is their cash flow situation (i.e. are they taking in more than they are paying out)?
- What is their business model?
- Who are their competitors?
- How solid is their management team?
To answer these questions, fundamental analysis relies on a mixture of qualitative and quantitative data. This is where some eyes start to glaze over, so let’s make it simple. Applying fundamental analysis allows investors to evaluate the financial health of a company (quantitative data) and consider it with the reputation of the company and other market conditions (qualitative data).
Why is fundamental analysis important?
When a company is offering you the opportunity to buy stock, they are asking you to buy a piece of their company. With that in mind, it's important for you to not only understand if the company is a good investment but if it is a good investment at that price.
Most investors who practice fundamental analysis are looking to buy stocks and hold onto them for an intermediate or long time frame. They are sometimes considered value investors. That's because these investors are looking for stocks that they perceive to be undervalued and therefore are likely to grow over time. However, that growth may not be fully realized for months or years.
Warren Buffett is one of the most notable examples of this type of investor. He has owned companies like Apple and Coca-Cola for years, even decades. In fact, he has famously said he will never sell his stock in Coca-Cola. Why? Their fundamentals. For that same reason, he has said he would love to own all of Apple’s stock. Do you see the key word in that sentence: own. Buffett understands that his investments represent an ownership stake in those companies.
In the world of personal finance, it’s fairly easy to understand the concept of value. When you go grocery shopping, there are certain items that you only buy when they’re on sale. Why? Because those items only have value to you at the right price. If you’ve ever bought a house or car, you know that you can get into trouble if you allow your feelings to get in the way of seeing whether or not what you are buying has value.
It’s the same way with buying stock. The problem is it’s much easier to understand the value of a house than it is to find the value of a company. So let me go back to the fantasy football example. There are people who will literally spend hours poring over “deep analytics” to find a running back to pick up on waivers in a league that they’re playing in for free. But they won’t spend five minutes looking at a balance sheet for a company that they have thousands of dollars invested in.
The larger point is that we are capable of learning anything that we apply ourselves to. Did many fantasy football owners understand how to evaluate players when they started? No, but they took the time to understand them.
Companies are asking you to spend your money to buy equity in their company. You have a right, and an obligation, to do some basic fundamental analysis.
What quantitative fundamentals should I be looking for?
There is no secret formula for determining a stock’s fundamentals. You need information and the ability to understand what it means. One of the best ways to get a sense of the financial health of a company is to look at its balance sheet. But if you’re new to fundamental analysis, there are some fundamentals that are readily available on a company's website or through other free, online resources. Not every stock you look at will check the box in every category, but what you're looking for is those stocks that are strong in most areas and come close on the others.
- Earnings – Otherwise known as the bottom line. How much profit a business earns after taxes and dividend payments. As a prospective investor, you’ll want to look for “earnings per share.” This is the earnings number divided by the average number of outstanding shares for whatever period they are reporting (most companies report quarterly earnings). You are looking for a steady pattern of earnings growth over a substantial period of time. Another thing to look for is how much of their earnings go back into the business. You can calculate this by comparing the earnings per share number with the dividend payout. Whatever isn’t being paid out as a dividend is going back into the business.
- Price-earnings (P/E) ratio – This is the price of one share divided by the earnings per share. If a company’s stock is selling for $50 a share and the company earned $5 a share, the P/E ratio is 10. The significance of the P/E ratio is that it tells you how much money investors are willing to pay for each dollar of a company's earnings. You can easily compare one company's P/E ratio to its competitors and other like-sized companies to see if they are trading at a discount to the market or at a premium. In general, a lower P/E number (10 or less) is better than a high one (20 or above).
- Dividend yield (if applicable) – for companies that pay out dividends, this is the company’s dividend expressed as a percentage of the share price. So going back to our example, a stock selling for $50 and pays $3 a year in dividends has a dividend yield of 6%. You are looking for companies with a strong history of raising dividends, ideally combined with rising earnings.
- Book value – the difference between a company’s assets and its liabilities. The book value by share is calculated by dividing the company’s book value by its number of outstanding shares. Ideally, you are looking for companies whose stock is selling at a price no higher than 1.3 times book value per share.
- Return on equity – this is a company’s net profit after taxes divided by its book value. You are looking for a return on equity that is higher than comparable businesses in the same industry or sector. Companies that consistently report a return on equity of over 15% are usually managed well.
- Debt-equity ratio – Simply put, how much debt a company has on their books compared to the equity they are generating from shareholders. If a company has $1 billion in equity and $300 million in debt, its debt-equity ratio is .30 or 30 percent. The lower the number the better, although there are other factors that should be considered on a case-by-case basis.
- Price volatility – This is typically expressed as a stock's "beta" and it lets you know how much investors should expect a stock to move relative to the S&P 500 stock index. The volatility of the index is used as the standard: a beta of 1.0. A beta above 1.0 means that the stock rises or falls by a percentage more than the index. A beta below 1.0 means that the stock rises or falls at a percentage that is lower than the index. In general, you should look for companies with a beta of around 1.0.
What qualitative fundamentals should I be looking for?
Qualitative fundamentals are those things that are harder to measure in numbers, or in other cases, where the numbers don’t necessarily provide a clear picture. For example, some investors would consider Apple to be overvalued based on quantitative measures. However, the perception of the company is so strong that it tends to overcome any negative impressions. Here are some qualitative measurements investors should look at.
- Is the company in a rising industry? A company’s stock is more likely to grow in a big and expanding market. That’s because the best companies tend to be established companies in large markets. This doesn’t mean you should rule out new industries. Just think about all the new industries that have popped up in your lifetime and are now in every household. However, just because someone creates a new widget doesn’t mean there’s a sustainable market for it.
- Is the company a leader in its industry? This may also be expressed as market share. While market share would seem to be a quantitative number its meaning for a stock price is more qualitative. Leaders in an industry can have more impact on pricing (think Wal-Mart) and their new products tend to be more readily accepted, so they can get more sales from existing customers and attract new ones.
- How much does the company invest in research and development? If a company is a leader in their industry, they should be making a comparable investment in research and development.
- How much competition does the company have and who are their competitors? If a company has little competition in a market, or if they have patented technology that cannot be easily duplicated, then those companies have a better chance for growth than a company that faces a crowded marketplace where they will be fighting to get noticed.
- Does the company have a unique selling proposition? Is there anything about the company that makes it unique? What is their competitive advantage? This is particularly important if the company is not a leader in its industry.
- Is the company in an industry that is heavily regulated? Some industries are subjected to federal or state government regulations. These are generally done to protect the general public, but they can put pressure on a company's growth potential, which can make it less attractive as an investment. A good example of this is the pharmaceutical industry which may have to spend millions of dollars to ensure that new drugs can be approved by the U.S. Food and Drug Administration (FDA). These dollars are above and beyond the money, they spend on research and development.
The bottom line on fundamental analysis
Let’s be clear. Trying to figure out if a stock will move up or down is an imperfect science at best. Even the most successful investors will get it wrong. Fundamental analysis is one technique that every investor can use to better understand the short and long-term prospects of the companies they are investing in.
You may never become an expert, and you still may not be convinced you should be, but we hope that you’ll be ready to look at your investments with a more critical eye. After all, if Warren Buffett uses fundamental analysis, it might be a good thing for you to consider as well.
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