Fundamental analysis is one of the methods, helping investors find best financial instruments to invest in. It uses fundamentals (like earnings of the firm, dividend prospects of the firm, expectations of future interest rates, predictions of future earnings of the firm, growth plans of the firm, economic situation of a country or particular industry, etc.) in order to maintain perspective and forecast future financial performance of the company, and in result, possible price movements. Fundamental analysis is generally used for long-term investments.
Fundamental analysis usually starts with financial statements analysis. It is done in order to determine existing trends (for example growth of profits or decline in turnover), and often to calculate various ratios, useful during comparisons of companies. Analysis of financial statements consists of: analysis of balance sheet, analysis of statement of operations and analysis of statement of cash flows. This analysis provides analyst with list of current indicators and ratios, which can be used to compare company's performance during period of time, or to compare it to the competition. All indicators should be presented in comparable form.
Most useful current indicators and ratios
Growing sales reflects growth of the company, can indicate the need of further growth. Fundamental analysis should show not only the changes in volume, but also reveals reasons of this changes.
This indicator is obtained by dividing net profit by total sales, the result is presented as a percentage. In order to calculate net margin, analyst should use net profit after taxes, presented in financial statement. Net margin should be steady and consistent. When it is almost equal year by year, it shows that company is performing well.
PE ratio (price to earnings ratio) is published in financial listings, and is often used in order to compare various stocks. It is not fully fundamental indicator, because it requires usage of current price of share, to calculate it. Partially it can reflect popularity of particular stock. PE value is calculated by dividing price per share by annual earnings per share. This ratio shows how much one unit of earnings is worth, in market's opinion. It can be interpreted in two ways. Firstly, low PE ratio shows, that market is not interested in particular stock, but this situation might change. Secondly, high PE ratio, shows, that stock is popular, but it also shows market expectations about future earnings potential, and because of this shows higher risk connected with possessing this stock.
- Bodie, Kane, Marcus, Investments, McGraw-Hill Primis, 2003, page 348
- Thomsett M. C., Mastering Fundamental Analysis|fundamental analysis, Kaplan Publishing, 1998, pages 28–36
- Abarbanell, J. S., & Bushee, B. J. (1997). Fundamental analysis, future earnings, and stock prices. Journal of Accounting Research, 35(1), 1-24.
Author: Mateusz Bąk