What is Fundamental Analysis in Stock Investing?

by | Jul 26, 2023 | Research

The reason you should invest your money is clear – compound returns can help you achieve your goals faster and with less money out-of-pocket. However, there are thousands upon thousands of potential stock investments, so how do you decide which companies are worthy of investment?

One way to evaluate stocks is fundamental analysis. With this method, you can determine which companies you expect to perform well in the future by evaluating a few key metrics.

What is fundamental analysis?

Fundamental analysis is a method for evaluating stocks based on information that is “fundamental” to the business’ success. Often, this data – such as revenue, debt, and earnings – can be found in the company’s financial statements.

This company data helps you measure the stock’s intrinsic value – how much it should be worth based on financial, market, and economic conditions. Then, you can compare the intrinsic value to the market price – the current selling price – to determine if the stock is a viable purchase.

Determining A Stock’s Intrinsic Value with Fundamental Analysis

There is no standardized method for determining the intrinsic value of a stock, but there are several common techniques analysts use to estimate it. Some of the most common methods are:

  • A dividend discount model. This type of model estimates the future dividends that the company will pay to shareholders and discounts them to arrive at a present value.
  • A discounted cash flow model. This type of model is similar to a dividend discount model, but it uses the company’s estimated future cash flows rather than dividend payments.
  • Asset-based valuation. The most basic way to estimate intrinsic value is to subtract total liabilities from total assets then divide by the number of outstanding shares.
  • Financial metrics. This method involves reviewing a company’s financials to determine the health of the company. This could include reviewing data points, like debt-to-equity, earnings-per-share, EBITDA, or a multitude of other commonly reported financial metrics.

These calculations can give you a starting point for evaluating a potential stock investment. However, it is often unwise to rely on just one calculation to determine your investing strategy. That’s why many investors use multiple data points to drive their decisions.

Common Financial Metrics Used in Fundamental Analysis

As previously mentioned, there are several metrics that can help you determine a stock’s intrinsic value. These financial metrics can provide a more comprehensive view of a company and their decisions.

Many of these are so widely used that they are available on stock quotes while others require some basic calculations. Some common fundamental analysis metrics include:

  • Debt to Equity [D/E]. This ratio can help you understand how much debt a company holds. Companies with significant debt, and therefore a high D/E ratio, can be at risk of default. On the other hand, debt can signal future growth, so it is important to understand what objectives the company is funding with its debt.
  • Earnings Per Share [EPS]. This metric shows how much profit a company generates per share of stock. This number is valuable in measuring profitability of a company and in calculating the P/E ratio (detailed below).
  • Earnings Before Interest, Taxes, Depreciation and Amortization [EBITDA]. This metric provides an alternative way to measure profitability. Some people prefer this measurement to Net Income because it excludes non-cash items.
  • Return on Equity [ROE]. This metric seeks to determine how efficiently a company generates profits by comparing net income to shareholder equity. A higher ROE is generally considered a signal of higher operating efficiency.
  • Price to Earnings [P/E] Ratio. This ratio is one of the most popular methods for evaluating a stock as an investment. It compares the current price to the company’s reported earnings to determine investor sentiment. A high P/E ratio indicates that investors place a high value on the stock. This could mean one of two things – investors anticipate higher returns in the future, or the stock is overvalued.

Financial metrics seek to make sense of the financial position of the company. However, to choose a wise investment you should also consider intangible factors, such as the quality of management, any news that could impact the stock price, and competition within the industry.

Using Fundamental Analysis to Choose Stocks

Fundamental analysis helps you identify a disconnect between a stock’s intrinsic and market values. Since the stock’s intrinsic value estimates how much the stock should be worth, you would generally expect the market price to move toward the intrinsic value over time – that is, if you subscribe to the theory of efficient markets.

During your analysis, you may find a stock with an intrinsic value far above its market price. In this case, you may consider purchasing the stock if it matches your situation. That’s because you would expect the value to rise over time.

On the other hand, you may find that a stock’s intrinsic value is far below its market price. In this scenario, you may choose to avoid purchasing that stock since you would expect its value to fall over time.

You can also use fundamental analysis when rebalancing your portfolio. For example, if you were reviewing your portfolio and found you owned too much of a particular sector, you could use fundamental analysis to analyze all your holdings in that sector. Then, you could sell the stocks that were overvalued.

Combining Fundamental and Technical Analysis Can Give You a More Complete Picture

While we’ve discussed fundamental analysis in depth, it is not the only method for evaluating stock investments. Another popular option is technical analysis. This type of analysis studies patterns in trading volume and price to make predictions about a stock’s future price.

Technical analysis assumes that investors buy and sell stocks based on all publicly available information. In this way, the accuracy of technical analysis depends on traders using fundamental analysis.

Fundamental and technical analysis can be used separately or together. For example, you could use fundamental analysis to find an undervalued stock, then use technical analysis to decide a good time to buy.

Fortunately, you don’t have to do the analysis yourself. If you partner with a wealth manager who specializes in stock investing, they can help you find stocks to buy and advise you on when to sell.

Get Your Investing Gameplan™ from DreamWork Financial Group

At DreamWork Financial Group, our advisors use both fundamental and technical analysis principles to develop your Investing Gameplan™. This unique wealth management program includes a custom portfolio of ETFs and individual stocks chosen for your specific situation.

Our driving goal is to provide fiduciary advice that is innovative, inclusive, and transparent. In keeping with this goal, Investing Gameplan™ is open to investors of any net worth. That’s why with DreamWork Financial, You Don’t Have to be Wealthy to Have Wealth Management®.

To learn more or get started, contact us.

Article Topics: Wealth Management