Fundamental stock analysis — How to do it?

Fundamental analysis is a key tool for investors who want to understand the fundamental value of stocks and other investment instruments. It is based on a thorough review of all available financial data and economic indicators of the company, in order to assess its intrinsic value.

In contrast to technical analysis, which focuses on stock charts and market trends, fundamental analysis examines factors such as a company's profitability, revenue, costs, market share, competitiveness, and the broader economic situation.It includes the analysis of financial statements and other publicly available reports with the aim of making informed investment decisions.

Fundamental analysis is a key tool for investors who want to understand the true value of stocks and other investment instruments. It is based on a thorough review of all available financial data and economic indicators companies, in order to assess its intrinsic value.

Let's take a look at everything you need to know about fundamental analysis.

Input data for fundamental analysis

In fundamental analysis in addition to the content of the business (products, competitive advantages, markets, etc.), we mainly analyze the financial statements of the company.Namely, the financial indicators of the company are based on financial data derived from the three basic financial statements.

These are:

• Balance sheet— The balance sheet shows the financial position of the company on the last day of the fiscal period. It shows the assets and liabilities to the sources of funds, as well as the equity of the company.
• Profit and loss statement— The income statement shows the financial performance of a company over a period of time, usually quarterly or annually. It shows income, expenses and net profit or loss.
• Statement of cash flows— The cash flow statement shows cash transactions over a period of time, again usually on a quarterly or annual basis. The composition of it is as follows:
  • cash flow from operations,
  • cash flow from investments,
  • cash flow from financing,
  • the final balance of cash; and
  • net change in cash.

When analyzing financial reports and financial indicators, we must always consider the figures in a specific context. The three most common contexts are usually:

• Financial history of the company — We analyze how the company's business evolves over time.
• Average values in the industry — We compare financial data in relation to industry averages and how the company lags or outperforms the industry.
• Comparison with competitors — We compare the financial health of one competitor with another or more companies operating in the same or similar industry. Sometimes it makes sense to analyze and compare companies from different sectors, but in doing so we must be careful to compare their comparable parts with each other.

When analyzing financial data, we are interested in five main aspects of the company's operations:

• ProfitabilityIs the company making a profit?
• Liquidity Can the company meet its short-term obligations?
• EffectivenessAre the company's operations effective?
• LeverageHow much debt does the company use?
• Growth How fast are the company's revenues and profits growing?

The most common indicators in the analysis of financial statements are the following:

Fundamental analysis — Key indicators derived from the balance sheet

In fundamental analysis, we usually calculate and analyze the following indicators that results from the balance sheet:

1. Short-Term Coefficient

The short-term coefficient is the ratio that measures whether an entity can use its current (current) assets to settle its current liabilities(these are obligations that are due within one year).

It is calculated as the current assets of the company divided by current liabilities. If the ratio is greater than 1, it means that the company has enough current assets to cover its short-term liabilities. A good liquid ratio is considered to be that above 1.2.

2. Fast Coefficient

The quick coefficient says whether the entity can meet its short-term obligations with cash, cash equivalents, accounts receivable and marketable securities.

In practice, these funds are often referred to as “quick funds”, since they are either cash or can be quickly converted into cash. To calculate the quick coefficient, we divide the quick assets by all current liabilities. A good fast ratio is higher than 1.0.

3. Long-term debt

Long-term debt is debt of a company that has a maturity of 12 months or more. The long-term solvency of the enterprise (solvency) depends on the level of long-term debt.

4. Debt to equity ratio (D/E)

Debt to equity ratio compares all the debt of the company (short and long term) with the equity of shareholders. It shows the so-called financial leverage of the company.

In practical terms, it shows how much debt a company has for each euro of capital. A good D/E ratio varies from industry to industry, but generally the rule of thumb is used in most industries that the ratio should not be higher than 2.0.

5. Interest Coverage Indicator

The interest coverage indicator shows whether the company can easily pay interest on its debt on time. It is usually calculated as EBIT (profit before interest and taxes) divided by the cost of interest in a certain period. The indicator should be above 2.0, and ideally even above 3.0 or higher.

6. Asset Turnover Indicator

Turnover ratio of assets measures the efficiency with which a company uses its assets to generate revenue.It is calculated as total sales divided by average assets. The higher the ratio, the more efficient the company.

For example, if the ratio is 2.0, it means that the company generates 2 euros of sales for each euro of assets. The ratio varies from industry to industry, so it is only necessary to use it to compare companies in the same industry.

7. Return on Assets (ROA)

ROA shows how profitable a company is in relation to its total assets. In other words, shows how efficiently the company uses funds to make a profit.

It is calculated as net profit or loss divided by average assets. A higher ROA indicates that the company is more efficient in using its assets to generate profits.

8. Return on Equity (ROE)

ROE shows how profitable the company is in relation to equity (net assets, not taking into account debt). It is calculated as net income divided by average equity and measures how much profit the company generates for each euro contributed by shareholders.

A rising ROE is usually a sign that a company is creating value for shareholders.There is also a more detailed analysis of ROE called Du-Pont analysis, which breaks down ROE into profit margin, asset turnover ratio and equity multiplier.

Fundamental analysis — Key indicators derived from the profit and loss account

In fundamental analysis, we usually analyze the following data and indicators arising from the income statement:

9. Revenue growth rate

Revenue growth simply means an increase in revenue over a period of time, usually quarterly or annually. It shows how fast a business is expanding and is often used to predict future revenue.

10. Growth rate of net profit or loss

The growth of net profit shows the increase in profit over a certain period of time. As with income, we can analyze whether the net profit or loss of the company increases or decreases over the years.

It is important that we compare the growth of net income with the growth of income and, in this way, see if the company is effective in converting increased revenues into increased profits.

11. Gross profit margin

Gross profit margin (engl. Gross profit margin is calculated as the difference between the income from sales and the cost of goods sold (engl. COGS) divided by sales revenue.

It shows the profitability of the enterprise after deducting the direct cost of the goods sold. The higher the gross profit margin, the better, since the company has more money left to cover other indirect costs (sales costs, general expenses, management costs, etc.).

12. Profit margin

It is calculated as the fraction between net profit and loss of sales. It shows how much net profit the company obtains for each euro of sales generated.

A higher net profit margin is, of course, better, and values vary considerably from one another depending on the industry in which the company operates.

Fundamental analysis — Key indicators derived from the statement of cash flows

In fundamental analysis, we usually analyze the following data and indicatorsarising from the statement of cash flows:

13. Operating Cash Flow (OCF)

This is the part of the cash flow statement that shows how much net money a company generates from its core business operations over a period of time (sales of goods and services, payments to suppliers, taxes, etc.).

It shows whether a company generates enough cash flow to maintain and expand its business operations. Positive cash flow from operations indicates that the company can meet its obligations only with operating income, without additional borrowing.

The other two types of cash flows in the statement of cash flows are:

• cash flow from investment activities; and
• cash flow from financial activities.

The cash flow from investing shows how much money the company has generated or spent through investments (purchase or sale of assets such as facilities and equipment, etc.). Cash flow from financing, on the other hand, shows how much money the company has generated or spent through financial activities, such as taking or returning loans, paying dividends, etc.

Valuation and attractiveness of society

In valuation, the key question is whether a company's stock is an attractive investment. There are several valuation metrics that help us assess the attractiveness of an investment.Listed below are some of the most commonly used.

14. P/E Ratio

The ratio of share price to earnings per share is probably the best known evaluation metric.It is calculated as the stock price of a share divided by earnings per share and shows how many years it would take for the company to return the amount paid for the share, assuming the company does not grow and pays out net profits to investors in full.

In other words, how much the investor must invest to receive the euro of the company's profit. The P/E ratio is one of the most popular indicators that shows whether a company is undervalued or overvalued. The long-term average P/E ratio for S&P 500 companies is around 14-16. The P/E ratio can range from 5x to 120x (or even more) depending on market cycles.

• Stocks with a high P/E ratio can be considered rising stocks, which means that investors expect high rates of growth and profitability in the future and are therefore willing to pay more for a share; this could also be an indicator that the stock is overvalued.
• Shares with a low P/E ratio can be considered as value shares if other criteria for classifying a share as a value share are also met.

15. P/B ratio

Share price to book value ratiocompares the market capitalization of the company with the book value.It is calculated as the quotient between the stock price of a share and its book value (BVPS).

The book value shows the net difference between the company's assets and liabilities, as well as the company's net assets, i.e. how much shareholders would receive if the company were liquidated.

Traditionally, a P/B ratio of less than 1 is considered a good investment (it means that the company is undervalued), but a P/B ratio of 4 can also be considered an acceptable investment, especially if it is a company with “light assets” such as companies in the technology sector.

16. P/S Ratio

The ratio of share price to sales per share is calculated asthe market capitalization of the company divided by the total sales in the last 12 months. The ratio shows how the company is valued in the market for each euro of the company's sales.

The ratio varies considerably between different industries and is most often used when comparing competitors. It is also often used in cases where growing businesses are not yet profitable.

17. Company Net Worth (EV)

EV ji me re vedibêje, how much money would be needed to buy the entire company and pay off all its debt.

It is calculated as market capitalization plus debt minus cash and cash equivalents (since they can be used to partially repay the debt). EV can be used as a better way to calculate the value of a company compared to market capitalization alone.

18. HOME/EBIT

It is an alternative P/E valuation metric that, unlike P/Etakes into account differences in debt structure, tax rates and larger amounts of cash on balance sheets.

It neutralizes the capital structure and is calculated as the profit value divided by the operating profit of the company or EBIT (profit before interest and taxes). For capital-intensive companies, EBIDTA (earnings before interest, depreciation and taxes) can be taken into account instead of EBIT, also taking into account the impact of depreciation.

19. PEG ratio

The purpose of the PEG ratio is take into account the expected growth rates of the company and be considered an upgrade of the P/E ratio.

The PEG ratio standardizes the P/E ratio based on the expected growth rates of earnings per share. It is calculated as the P/E ratio divided by the expected growth rate of earnings per share. A PEG ratio below 1 is considered “good”.

20. Dividend yield

Dividend yield is percentage of the stock price of a company's share that is paid as a dividend each year. It is calculated as dividends per share paid in the year divided by the share price. Higher dividend yields are generally better.

A dividend yield of between 2% and 6% is considered good. Of course, there are also exceptions, for example, if a company pays out too many dividends instead of reinvesting in growth, or if it pays too many dividends when business does not go as expected and capital reserves become too small.

21. Dividend payout ratio (current, future)

The dividend payout ratio can helps determine whether a company is paying out a reasonable share of its profits.The ratio is calculated as all dividends paid in the year divided by net profit.

In other words, it shows us what percentage of the net profit was paid as a dividend. A payout ratio between 30% and 50% is considered good and sustainable.

22. Number of shares/New issued shares/Purchase of shares

It is important for investors how many shares are on the market and if new shares have been issued.The issuance of new shares results in dilution of shareholders, which means that an investor holding the same number of shares has a lower percentage of ownership of the company after the issuance of new shares.In addition, if too many shares are issued too quickly, the stock price may fall due to a higher supply.

The opposite of issuing new shares and raising new capital is called share repurchase. A company with extra money can make new investments, pay dividends or buy back its shares. Share buybacks are a form of returning capital to shareholders, as these shares are withdrawn from the market or kept as treasury shares. Buyout can also indicate that management considers the company to be undervalued.

The fundamental analysis isan invaluable tool for any investor who wants to transcend surface trends and understand the true value and potential of companies.By providing insight into companies' financial health, operational efficiency and market position, fundamental analysis enables the design of a deeper, data-driven investment strategy.

While it can be challenging and time-consuming, its ability to uncover long-term opportunities and risks makes fundamental analysis indispensable for those striving for thoughtful and informed investing.