All about Stock Fundamental Analysis

Stock fundamental analysis involves assessing a company’s financial health and aims at finding a company’s intrinsic value.

The term “intrinsic value” is used quite a lot in trading, when applied to stock trading, basically it is just a posh way of saying what you feel a company is worth.

The main factors that are used when trying to establish a company’s intrinsic value are:

The management and competitive advantages a company has.
An example of a competitive advantage might be if microsoft wanted to open an online DVD store, they could provide links to their store from the windows media player software that comes free with microsoft windows.

Whereas a completely new company without an established brand would not have such an advantage.

Other competitive advantages include price and quality of a product. If a company is able to supply a better quality product at a cheaper price than its competitors, it may give have a considerable competitive advantage.

The current economic climate
Some industries are very sensitive to the economic climate. An example would be the car industry. During the 2008-2009 global recession many major car firms were struggling. In fact the well known and long time established car manufacturer General Motors went into chapter 11 bankruptcy on the 1st June 2009. More can be read about the bankruptcy here.

A recession doesn’t always mean a business well not perform as well. In fact some businesses even do better during an economic down turn. Often these are businesses that help people save money, like budget food stores.

Level of Competition and demand
The level of competition can be a big factor in future profitability. For example, if I was to setup a online book store, it would be a very difficult to make a success of it as there is a lot of strong competition like amazon.com.

However, not possible, because there is huge demand for books both online and offline. According to google over 50 million people a month search for books.

So as you can see, supply and demand can greatly affect a business’ profit potential.

Size of the market and market share
The size of the market and the market share a company currently holds is a big factor in future profitability. Lets take a look at microsoft, the world’s biggest software company. Their biggest product is their operating system, MS windows.

In July 2009 google announced they are working on an operating system. Google claim the operating system is going to be open source, meaning anybody can obtain it at no cost. If the operating system does rival MS windows, this could seriously hurt microsoft’s market share in the operating system market and in turn hit future profits.

Stock Ratios

Stock Ratios are also commonly used in stock fundamental analysis. The most commonly used ratios are:

Earnings per share (EPS)
The earnings per share is a very important indicator as it gives us the earnings on the money invested. The EPS also takes into consideration outstanding shares. To work out the EPS, you divide the net earnings by the number of outstanding shares of common stock.

Price/Earnings (P/E ratio)
The P/E ratio tells us how many times more a company share price is than its income per share. To work out a company’s P/E ratio simply divide the share price by the earnings per share.

For example, if a company’s share price was $10 and the EPS $3.33, the P/E ratio would be 3.

Price/Book Ratio (P/B ratio)
The P/B ratio compares a company’s stock market value to its book value. It is also commonly referred to as the price to equity ratio. To calculate the P/B ratio you need to divide the stock price by the sum of tangible assets – liabilities.

It is important to be aware that these ratios can vary greatly between different market sectors. For example the energy sector has an average P/E ratio of around 5, whilst technology companies have an average of around 60.

Advantages of fundamental analysis

  • Excellent for long term trading and buy and hold strategies.
  • If you get deep into stock fundamental analysis you are likely to end up with very good business acumen.
  • By understanding a specific market, it enables you to make more accurate long term predictions
  • You can develop strategies to find companies that are undervalued using stock ratios. 

    Disadvantages of fundamental analysis

  • Can be very labor intensive.
  • Ideally only suited to longer term trading.
  • It can be very industry specific. What works well for one industry may not for another.