Fundamental Analysis Basics

We wil breakdown what fundemental analysis actually is, as well you will see how to do it. We will tell you how the underlying calculation is made but don't worry if you don't get it. We only want to give you a conceptual understanding of how it works.

Fundamental analysis is a method of evaluating the intrinsic value of an asset, such as a stock, bond, or commodity. The term "intrinsic value" refers to the actual worth of an asset based on its underlying fundamentals, as opposed to its graphs or other factors.

The goal of fundamental analysis is to determine the underlying value of an asset by examining a variety of qualitative and quantitative factors that could affect its performance. These factors can include financial metrics such as revenue, profit margins, earnings growth, cash flow, and debt levels, as well as qualitative factors such as the quality of the company's management team, its competitive position within its industry, and broader macroeconomic trends that could affect its performance.

You can input your own filters into a screener that gets rid of unnecessary noise. Some of the best free screeners include:

Finviz

ET Markets

Money Control

Screener

Ticker Tape

Indicators of Fundamental Strength

P/E (Price to Earnings Ratio)

The ratio of the price per share of a company's stock to its earnings per share is known as the price-to-earnings ratio. Effectively a measurement of stock price and per share earnings. This is useful as it tells you if that stock is under or overvalued within that sector. Investors use the P/E ratio to evaluate how much the market is willing to pay for a stock based on its past or future earnings. A lower P/E ratio means the current stock price is low compared to earnings which may signal an undervalued security.

Here is the calculation:

Divide the current price per share by the company’s earnings per share, hence P/E.

EPS (Earnings Per Share)

Since we just explained P/E it is beneficial to now examine EPS. This indication tells us the amount of a company’s profit that is given proportionately to each share of its stock. You want an increasing EPS as it means that their shares are likely to be worth more in the future. The higher EPS relative to competition the better.

Here is the calculation:

Divide the total profit by the number of outstanding shares, hence Earnings PER Share.

FCF (Free Cash Flow)

This indication tells you how much cash is left over after that company has paid for its operating and capital costs. This is an important signal of the strength of that company as the amount of free cash is vital to the health of a business. Companies with high FCF have the ability to innovate and survive downturns better than their competition with lower FCF which can increase the shareholders value in a FCF rich organization. In addition it shows if a company has enough cash post expense to begin releasing dividends.

Here is the calculation:

Operating Cash Flow minus Capital Expenditures (CAPEX) as seen on the cash flow statement that the company provides. It can also be seen on the Income statement as Net Operating Profit After Taxes (NOPAT) plus depreciation, minus working capital and capital expenditure (CAPEX).

Some screeners like Finviz don't have a free cash flow filter so we just input “Over 5” for the Price/Free Cash Flow ratio.

PEG (Projected Earnings Growth)

The P/E ratio is limited as it doesn’t include future earnings growth. The PEG adds to the P/E by anticipating the one-year earnings growth rate of the stock. We do this as the PEG incorporates historical growth data into the calculation. Usually A PEG ratio above 1.0 suggests a stock is overvalued.

Here is the calculation:

To calculate, divide the P/E ratio by the company’s 12-month growth rate.

For example, if the growth rate is 5% and the PE ratio is 20, then the PEG formula looks like this:

• PEG = PE Ratio / Earnings Growth
• PEG = 20 / 5 -> the 5% turns into just 5
• PEG = 4

Price to Book Ratio (P/B)

This indicator compares the book value (what the company says in its reports) of a stock to its market value. The difference between the market value and the value the company has given helps show whether the stock is under or overvalued compared to book value.

Here is the calculation:

Divide the most recent closing price over the book value per share listed in the annual report.

Bottom Line:

It is important to recognize that we don't want to use P/B by itself as we have to compare it to its competition to get a sense of value. If we have a high P/B the stock is trading at a premium against the company's book value. So if a company has a price-to-book value of four, it means that it is trading at four times its book value. Usually anything under 1.0 is undervalued but once again you have to compare to competition.

Return on Equity (ROE)

This indication tells us the rate of return a shareholder gets for the portion of investment in that company. It shows how a company generates returns for its shareholders. It is a good indicator of the financial health and fair value of its stock.

Here is the calculation:

Divide net income by average shareholders’ equity.

Summary

P/E = We want a lower value compared to competition as it tells us stock price compared to earnings

EPS = We want a higher EPS compared to competition as it tell us profit given to each share of its stock

FCF = We want a high FCF as this signals the cash left over after paying for its operating and capital costs

PEG = We want a PEG value below 1.0 preferably as above 1.0 is usually overvalued

P/B = We want a lower P/B value of preferably under 1.0 as it tells us that it isn't trading at a premium relative to book value

ROE = We want a higher ROE value as it tell us the returns a company can get relative to shareholders equity

Concluding Remarks

The list of fundamental indicators that is provided above is used to serve as a useful starting point for understanding how to evaluate stocks. By familiarizing yourself with these indicators, you can gain a better understanding of the factors that influence a stock's performance, and how they are measured. This knowledge can then be applied when reading later tools about screener settings or other investment strategies. Additionally, having a solid grasp of these fundamental indicators can help you identify which metrics are most important for your investment goals, and how to interpret them in the context of the broader market.