Whenever you make a trade, you always ask yourself why it is a good idea. Fundamental analysis answers questions arising in your mind. Fundamental analysis is one of the two key stock analysis techniques. The second one is technical analysis. Both require great tools and in this article we’ll deep dive into fundamental analysis tools.
- Fundamental analysis is very effective to measure the intrinsic value of a stock.
- It evaluates the basic information at both levels, microeconomic and macroeconomic.
- The fundamental analysis enables you to gain information that complements your technical analysis.
- Fundamental analysis needs certain tools to analyze a company’s financial health.
Technical vs fundamental analysis
Technical analysis involves the study of historical price and volume data to predict future price movements. The fundamental analysis revolves around studying the financial basics or fundamentals of a company. Financial stats and ratios help to determine the financial status and growth potential of a company. And what else? It gives you a clear idea about the company’s stocks you want to trade.
Fundamental analysis is very effective to measure the intrinsic value of a stock. It evaluates the basic information at both levels, microeconomic and macroeconomic. It looks into the overall performance of a company at the microeconomic level. On the macroeconomic level, it studies the overall industry conditions and economic factors that affect a company’s performance.
Even if you use technical analysis to evaluate stocks, you need fundamental analysis as well to back up your trading decisions. The fundamental analysis enables you to gain information that complements your technical analysis. You can easily evaluate a company’s financial position, new developments, or news that can affect stock prices. In other words, you get a broader picture of stock’s potential that leads you toward better decision making.
Fundamental analysis needs certain tools to analyze a company’s financial health. So, how can you do the fundamental analysis? What are the fundamental analysis tools and how they work? Let’s discuss in detail what are the main and most widely used stock fundamental analysis tools.
What are the most widely used tools for fundamental analysis?
Fundamental analysis is crucial for stock market traders because it helps traders in many ways. It helps to determine whether the stocks of a company are overvalued or undervalued. Fundamental analysis helps traders to determine the financial health of a company. It also helps to forecast the growth potential and prospects of a company. Fundamental analysis takes the following key factors into account in order to provide such important information.
- Financial reports
- Productivity and product or service demands
- Asset management
- Management style
- Press releases and news
- Current and upcoming trade agreements
- Government’s external policies and the overall economy
However, the financial report of a company is the most important factor in the fundamental analysis as it affects share prices. A company’s net earnings reveal the progress and growth potential of a company. Higher levels of earnings move stock prices up and vice versa. But, earnings and profits do not reveal all about how stocks are valued in the market. Thus, you need more tools for fundamental analysis. The following tools can help you get an HD picture of a company and its stock’s valuation.
Earning per share is the amount of profit that each stock is entitled to receive. It is calculated by dividing the net income by the total number of stocks. EPS reveals the financial progress of a company and how much shareholders earned in a financial year.
Fundamental analysts don’t rely on the trailing EPS and calculate current and forward EPS as well.
- Trailing EPS is the recently completed fiscal year’s EPS.
- Current EPS is the current fiscal year’s project EPS.
- Forward EPS is the forecasted EPS of the next fiscal year.
EPS not only gives a good idea to analyze a company’s performance. Traders can compare it to other companies to find out a better option.
2. Price to earnings (P/E) ratio
Price to earnings ratio is the second most important stock fundamental analysis tool. It indicates a company’s stock prices in relation to its earnings. A lower P/E ratio reflects higher incomes in relation to the prices and its stocks are a good trading option. Conversely, a higher P/E ratio signifies lower incomes as compared to stock prices. It means stocks are overvalued and aren’t a good trading option. An average P/E ratio suggests undervalued stocks but with the potential to go up in the future.
The importance of the P/E ratio as a fundamental analysis tool varies from one trader to another. It indicates how much a trader or investor is willing to pay for stocks in relation to the company’s earnings. Thus, willingness varies from person to person, as does the importance of the P/E ratio as well.
3. Return on equity (ROE)
Return on equity reflects how much return shareholders get in comparison to their equity. Companies with higher ROE show their efficiency of generating higher profits against shareholders’ investment. Those companies are good options for stock trading or investing. But, companies without much equity and assets also have higher ROE. Therefore, a higher ROE doesn’t necessarily mean good trading or investment opportunity. You should compare a company’s ROE with the other companies in the same industry. The ROE of a company between 13 to 15 usually indicates a good opportunity to invest in stocks of that company.
4. Price to sales (P/S) ratio
Price to sales ratio is another important tool for fundamental analysis. It indicates a company’s efficiency to generate revenues as compared to its stock prices. A lower P/S ratio suggests undervalued stocks while an above-average P/S ratio indicates overvalued stocks.
5. Price to book (P/B) ratio
The price to book ratio is a comparison of a stock’s book value and its market value. It is an important fundamental analysis tool that reflects whether a company’s assets are at par with its share’s market value or not. Companies in the finance, investment, banking, and insurance sectors value the P/B ratio more because of their higher liquid assets. Companies having more fixed assets get very little help from price to book ratio. In general, a P/B ratio greater than 1 indicates overvalued stock, and a P/B ratio less than 1 signifies undervalued stocks.
6. Dividend yield and payout ratio
These are among the key fundamental analysis tools. Dividend yield indicates how much dividend shareholders received as compared to stock price. The dividend payout ratio signifies how much dividend shareholders received from a company’s total net profit.
Fundamental analysis is one of the two main techniques to analyze the stocks of a company. Technical analysis involves the study of historical price and volume data to predict future price movements. The fundamental analysis revolves around studying the financial basics or fundamentals of a company.
Fundamental analysts make use of some key fundamental analysis tools to predict or forecast future stock prices. If analysts expect a company a better performance, they invest in that company. The reason is the forecasted future prices are higher than the current market prices. Conversely, they consider selling stocks when stocks are overvalued because the intrinsic values of stocks are low. Thus, fundamental analysis tools can help you get a clear picture of a company’s financial performance. And, help you closely monitor the stocks you want to trade or invest in.