Investing in stocks becomes more and more accessible every day because of the technological progress we witness on a daily basis. Approach every stock trade with due diligence. Your analysis is what helps you decide whether a stock is a good investment or not.
There are 2 types of analysis related to stock trading — technical analysis and fundamental analysis. We’ll give you the best research tools to conduct fundamental analysis and show you how to use them.
Main Takeaways: Using Fundamental Analysis
- Technical analysis and fundamental analysis are the 2 main types of analysis-related stock trading. Fundamental analysis evaluates certain securities to create forecasts about its price in the future.
- This type of analysis uses specific indicators. These include EPS, P/E ratios, beta and more. We explore what each of these are, and the role they play, below.
- A great company to use for technical analysis is Amazon. We break down an example below as well.
What is Fundamental Analysis?
Fundamental analysis is the process of evaluating security for creating forecasts about its future price. Fundamental analysis includes estimations based on many components related to stock, including:
- The global industry
- Company financial statements
- Company press releases
- News releases
- Domestic political conditions
- Trade agreements and external politics
- Competitor analysis
If some fundamental indicators of a company show data that has a bad impact, this is likely to negatively reflect the share price. On the other hand, if there’s a positive data release, like an outstanding earnings report, for example, this can boost the stock price of the respective company.
Here are some examples of key performance indices that are commonly used to analyze stocks fundamentally:
- Earnings per share (EPS)
- Price-to-earnings (P/E) ratio
- Price-to-book (P/B) ratio
- Return on equity
Each of these key performance indices gives information that is helpful for conducting a price analysis. You can buy the stock on the assumption that the price will increase if your analysis shows that the price of the stock is about to increase.
A Detailed Example of Fundamental Analysis
There’s no right way to do fundamental analysis, as stock trading is not as accurate as a math problem. The same information in different industries and different stocks will never mean the exact same thing. Here are a few of the most important fundamental indicators.
Earnings Per Share (EPS)
The earnings per share relate to the portion of profit allocated to each of the company’s shares. The EPS is an indication of the company’s profitability. The higher the earnings per share, the better it is for the investor. A higher EPS is a symbol of a healthy company.
At the same time, if the earnings per share are unusually high, this could mean one of the following things:
- Earnings can decrease and get back to normal.
- The price of the stock can increase to normalize the stock price compared to the earnings.
Price-to-Earnings Ratio (P/E Ratio)
The price-to-earnings (P/E) ratio shows the company payouts compared to the price of the stock. In other words, the P/E ratio shows whether a share of stock pays well compared to its price. We calculate the P/E ratio by dividing the price per share by the earnings per share.
For example, imagine that the price per share is $30 and the stock pays $2 earnings per share:
30 / 2 = 15
The lower the P/E ratio, the higher the earnings compared to the stock price.
At first sight, the lower the P/E ratio, the more attractive the stock. But if we think carefully we will realize that unusually low P/E ratio could show extra potential.
If the P/E ratio is too low, below 10 for example, this means that the price per share is low compared to the earnings. This might mean that the stock is undervalued in price and it can increase its price. The opposite is in force for the high P/E ratio.
Price-to-Book Ratio (P/B Ratio)
The price-to-book ratio is an indication that shows how much the stock worth compared to the book value of the company. If a company worth $10 million and has 500,000 shares outstanding, it will have a book value per share of:
10,000,000 / 500,000 = $20 book value per share
If the stock trades at $80 per share, then the price-to-book ratio is:
80 / 20 = 4 P/B ratio
The P/B ratio = price per share divided by the book value per share.
If the P/B ratio is more than 1, this means investors believe that the stock will grow at a faster pace, which is the reason why its price is higher than its book value. In some cases, you can even see P/B ratios of 100 and more. This could be a common parameter for the growth stocks.
Return on Equity (ROE)
The return on equity is a measurement that determines how efficient a company is when using the shareholders’ equity. You calculate the ROE by dividing the shareholders’ equity by the company’s net income. If a company has generated $5 million this year and the shareholder equity is $50 million, this means the ROE is:
50,000,000 / 5,000,000 = 10%
Note that you should calculate the ROE result as a percentage.
The higher the ROE, the more efficient the company is. If a company generates a less than $5 million income this year (say $2 million) with the same shareholders’ equity, this means it is less efficient:
50,000,000 / 2,000,000 = 4%
Here, the company has a lower ROE with the same shareholder’s equity, meaning that it is less efficient.
The beta gives information about the stock price’s correlation to the industry it operates in. This happens by comparing the stock to a benchmark index. The beta usually varies between -1 and 1. Sometimes values can go much lower than -1 or much higher than 1.
Values above 0 mean that the stock correlates to the benchmark index. The higher the beta, the higher the correlation. But the higher beta also means that the volatility is higher as well, meaning that the risk of the asset increases.
Values below 0 mean that the stock is inversely correlated to the benchmark index. It won’t be as a mirror image, but the ticks are likely to match. The lower the beta, the higher the inverse correlation. However, the lower the beta, the lower the volatility.
Fundamental Analysis of Amazon
Amazon is the ultimate symbol of the tech sector. The company has shown exponential growth, revenue and earnings over time.
Another important fundamental indication is that Amazon has beaten the EPS estimates in the past 4 years, and the outreach is exponential.
This earnings data shows that Amazon is healthy and aims for growth every year. And the best is that they are succeeding for now.
Earnings per share: $17.85
Notice that earnings per share of Amazon are very low compared to the stock price. This leads to the extremely high P/E ratio.
P/E ratio: 98.1
This tells us that a very small part of the earnings actually goes to the shareholders. This is totally normal for an IT company of Amazon’s rank. They constantly expand and reinvest funds in research and development. Some of the fields Amazon is currently working actively is robotization and artificial intelligence. Since the company spends a lot there, there’s not much left for the shareholders.
This offers up further information, however. Since Amazon invests a lot and aims to expand more, we can expect the company to grow even further, dragging the stock price up. After all, during the past 4 years, Amazon has grown in stock price by more than 40% on average.
P/B ratio: 19.88
A P/B ratio of nearly 20 is very high. This means investors are currently paying nearly 20 times higher price for an Amazon share compared to the book value of the company.
The return on equity of Amazon is high for the sector. Here’s a general comparison with other top tech companies from the S&P 500:
- Facebook ROE: 25%
- Microsoft ROE: 23.1%
- Google ROE: 11.6%
- PayPal ROE: 13.8%
Amazon is more efficient financially compared to the 4 companies above. Note that this doesn’t mean that Facebook, Microsoft, Google and PayPal are not efficient. It means they are efficient but less so than Amazon. In comparison, Apple has an ROE of 48.7%.
Amazon is a stock that is very correlated to the benchmark and the beta confirms this. Not only is it correlated, but it’s also one of the top 10 stocks of the S&P 500. A beta of 1.63 means that the stock is very volatile, which isn’t unusual for a huge multinational corporation that dynamically reinvests its funds.
Fundamental Analysis vs. Technical Analysis: What’s the Difference?
Fundamental analysis relies on the company’s parameters as you saw in our analysis above. Technical analysis, on the other hand, takes into consideration only price action and past price data.
Investors perform technical analysis on a chart. The goal of the technical analysis is to make assumptions based on past stock price performance. Pure technical analysts don’t rely on company data and fundamentals. They analyze charts and try to find patterns for recognizing future behavior.
At first sight, the technical analysis might sound unreasonable. However, there is a strong psychological correlation between price action and the psychology of market participants. Since the price of a stock formulates based on supply (sell) and demand (buy), turning points related to the price of a stock are likely to have an impact on the attitude of the market participants.
An example of this is the round number levels on a chart. If a stock approaches from below $100 per share, this level is likely to have a psychological impact on market participants. Many investors might think that the company has no capacity to expand above $100 per share and can sell their assets, creating supply and reducing the price of the stock.
Technical analysts use various tools to analyze the price action of stocks. Some of these are:
- Candle patterns
- Chart patterns
- Trend lines
- Price momentum
- Trading volume
Each of these tools and indicators has a different meaning and tells a story. But when matching signals from different indicators, a technical analyst attain signals with higher reliability.
The Best Research Tools for Fundamental Analysis
In most of the cases, your broker will supply you with the most important data you will need to conduct a fundamental analysis of a stock.
The platform includes a stock screener which lets you filter stocks based on different fundamental parameters. TD Ameritrade also harvests a lot of fundamental data and investing newsletters from sources like CNBC and Yahoo! Finance.
Finviz is a very adequate solution to screen fundamental stock data and has a sufficient free version.
This is what you will see when you search for a stock. The data includes the most important fundamental parameters of a stock.
Yahoo is one of the oldest providers of stock fundamental data. When you go to the Yahoo! Finance site, you will see a search bar and once you see what interests you, this is what you will get.
You’ll see different tabs at the top which contain extra fundamental information related to historical data, financial reports and statistics.
Be Familiar with Fundamental Analysis
Fundamental analysis is essential in stock trading. You need to be familiar with the basic fundamental indicators if you want to start investing in stocks so you can build a picture of the financial condition in a company — whether it’s financially efficient, sustainable and profitable.
Although the stock analysis is important, it is always good to pair it with technical analysis data. Always mind the important psychological levels on the chart, which might be a turning point. Try to match technical data with fundamentals. If you find your way to understand both of these languages, your analysis will reach a new level of comprehension.
Looking to improve your stock trading strategy? Check out our guide on how to create an investment strategy, or the best online stock brokers for beginners if you’re just starting to build your portfolio.