Fundamental analysis is one of the two main methods used to analyze the market. It is used to analyze stock trends and company finances to determine a security’s value. In this post, we explain the key aspects of fundamental analysis, so you can make investments with better confidence and data.
The main elements of fundamental analysis are:
– Price-to-Earning Ratio
– Earnings per share
– Revenue Growth
Fundamental Analysis is the review of a company’s quality related to its earnings per share, revenue growth momentum, and value based on its price to earnings ratio. This can be achieved by examining a company’s current and historical cash flows, balance sheets, and year-end statements in comparison to competitors. Investors who plan on holding securities for shorter periods of time tend to use this method to mitigate risk when valuing security.
Investors can tell when a stock is undervalued when its market price is lower than its fair market value. Ideally, an investor would purchase the stock and hold until the market price increases. However, when the stock’s price falls past its current fair market value, it could also be sold if fundamental analysis predicts an impending downward trend.
To help better determine if a stock is under or overvalued, investors take the following factors into consideration:
Revenue Growth is the amount a company’s profit has increased or decreased over time and is shown as a percentage. To calculate revenue growth, investors subtract the current year’s profit from the previous year’s profit and divide it by the previous year’s profit.
Revenue Growth = (Year’s Profit – Previous Year’s Profit) / Previous Year’s Profit
Earnings Per Share (EPS) or net income per share is the measure of a company’s profit assigned to each share. To calculate EPS, the net income is subtracted from the preferred dividends – and then divided by the number of outstanding shares.
EPS = (Net Income – Preferred Dividends) / Shares Outstanding
Price to Earnings Ratio (P/E Ratio) or “earnings multiple” simply compares a stock’s current sale price to its EPS (see above) from the last twelve months. It helps investors determine if they are purchasing securities at a fair price and with a solid return on investment (ROI).
P/E = Stock Price per Share / Earnings Per Share
A trailing P/E ratio analyzes prices to past earnings while a forward P/E ratio is based on projected earnings provided by the company’s management.
Sought-after stocks tend to be mature, dividend-paying companies with low P/E ratios. Often they are trading at a price lower than fundamentals typically indicate. They are purchased with the intention of holding until the market corrects itself and prices rise.
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