Fundamental analysis explained

Fundamental analysis is the process of looking at current, past and forecast company, industry and economic data and other qualitative information to determine what a company is worth per share. This estimate value is often called 'intrinsic value' and fundamental analysis assumes that, over time, a company's share price will reflect the company's intrinsic value.  It makes sense for an investor to buy shares when a company's price is less than its perceived value.

Areas of fundamental analysis

Quantitative analysis studies the financial measures from a company's financial statements and considers measure such as:

  • revenue
  • earnings
  • assets and liabilities
  • cash flow

These measures are often combined to produce fundamental or financial ratios that can be used to compare companies to other companies in the same industry, the overall market and previous ratios from the company.

Simple ratios that are often used are:

Dividend yield

The dividend yield is a calculation that shows how much a company pays out in dividends each year relative to its share price.  The yield is expressed as a percentage.

Dividend Yield = $ Value of dividend per share / share price

Price to Earnings Ratio (PE)

The price to earnings ratio is how much money you are paying for $1 of company earnings. For example if a company is reporting a profit of $2 per share and the share price is $20, then the PE ratio is 10, in other words you are paying ten-time earnings.

PE = Price per share / annual earnings per share

The PE is not very useful on it own, but it is a useful comparison tool, you can use it to compare a company against its peers in the same industry as well as compare it to historical performance.

Price to Earning Growth (PEG) ratio

The PEG ratio is a useful ratio which compares earnings growth and the PE ratio.  To calculate the PEG ratio:

PEG - Current PE / expected long term growth rate in earning per share

The rule of thumb is that a PEG of more than 1.0 is poor, a PEG of less than 1.0 is good and a PEG of less than 0.5 is excellent.

Return on equity

ROE is a measure of the financial performance of a company.  Shareholders equity is a company's assets less its debt. The formula to calculate ROE is:

ROE = Net income / shareholders equity

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