The fundamentals of a stock are the aspects on the basis of which we can determine the company’s or its actual worth. Often, analysts tend to use fundamental analysis to examine the dynamics of a stock. This means the examination of any sort of data that is expected to influence the price or value of a stock.
Meaning of Fundamental Analysis
The method of analysing basics of the company to figure out the “real” or “intrinsic” value of a stock is known as fundamental analysis. This analysis can be both quantitative and qualitative. Once the value is calculated, it can then be compared to the last traded price of the stock to make strategical investment decisions. Fundamental analysts work on the belief that market is not exhibiting the true worth of the stock. This contradicts the efficient market hypothesis which states that all stocks are correctly valued at all times.
Quantitative Components of Stock Fundamentals
Most of the quantitative metrics are accessible and they can be used to compare stocks within the same industry. Simply put, fundamental analysis helps in measuring a security’s intrinsic value by monitoring related economic and financial factors. Fundamental analysis involves the study of anything which can affect the security’s value, from factors like state of the economy and industry conditions to factors including effectiveness of the management.
However, some of the most popular quantitative metrics which are used in the fundamental analysis are listed below:
Earnings Per Share (EPS)
Earnings per share refers to the company’s net profit divided by its number of common shares it has outstanding. This indicates how much money a company makes for every share of its stock. More often than not, this is a widely-used measure for estimating corporate value. Following is the formula:
EPS = (Earnings – Preferred Dividends) / Number of Shares Outstanding
Price-to-Earnings (P/E) Ratio
The price-to-earnings ratio is a valuation ratio which compares a company’s current price relative to its earnings per share (EPS). The price-to-earnings ratio is also referred to as the price to earnings multiple.
P/E Ratio = Current share price / Earnings per share
Price-to-book (P/B) Ratio
The price-to-book ratio reflects the market’s valuation of a company relative to book value. This measure is calculated by dividing the price per share to the book value per share.
P/B Ratio = Current share price / Book value per share
Debt-to-equity (D/E) ratio
Debt-to-equity (D/E) ratio helps in evaluating a company’s financial leverage. Therefore, this measure is calculated by dividing a company’s total liabilities by shareholder equity. It can be expressed in a percentage or a decimal.
D/E Ratio = Total liabilities / Shareholder Equity
Dividend yield of a share refers to the ratio of dividends paid per equity share to its shareholders on the current price. This measure is calculated by dividing annual dividends paid by the current stock price. Simply put, it measures the quantum of cash dividends paid out to shareholders relative to current price.
Dividend Yield = Dividends Paid Per Share / Share Price
Qualitative components of a stock fundamentals
While quantitative measures are important as they provide investors with a common ground on the basis of which they can evaluate companies in a specific industry, qualitative factors are just equally important. Such factors can also help in understanding the basics of the company. These factors are those outcomes which cannot be quantified with hard data.
Some of the most significant are listed below:
A business model is referred to a framework for how a company will create value. At the time of calculating worth of the company, there can be instances where similar businesses might employ different business models even though they provide comparable goods or services.
Some companies within a specific industry might have advantages which are not available with others. Competitive advantage is referred to favorable position the company seeks to become more profitable in comparison to its rivals. Investors should look for such advantages that they believe will make one business more profitable than others. This allows a company to report superior margins and generate higher value for its shareholders. Competitive advantages might include an access to a specific technology, a well-established distribution chain, etc.
Even though some of a company’s business may be automated, the leadership team is in charge of research, growth, advancement, corporate reputation, strategy changes, etc. Such measures help in the overall success of the company in the long run. If leadership team is motivated enough, the company is likely to sustain challenges.
Corporate policies and ethics
Investors can gain understanding into a company’s principles and corporate governance by understanding how it engages with its workers, the public, other businesses, governments, etc. The main goal of establishing ethical policies is to build solid reputation. This measure is of utmost importance as it can impact how the company is being viewed by local and international communities.
Microeconomic indicators including supply and demand within a specific industry or market can help in determining the company’s success. Most investors should base their investment decisions on fundamental realities which are present in microeconomic theory. For example, if raw material used to manufacture a company’s product sees scarce supply, the prices might rise. This will eventually result into lower demand and lower sales. Thus, the profits will also get reduced.
Macroeconomic elements Individual companies can be impacted by macroeconomic factors including GDP data, inflation, employment levels, etc. For example, higher unemployment means the spending power is likely to be impacted. Therefore, demand of the goods will reduce which will impact the profits of several companies.