The Basics of Fundamental Analysis

Investors are always striving to find stocks that are not yet trading at fair market value. In order to find these stocks, investors will need to use a strategy called fundamental analysis (FA).

Fundamental analysis uses various economic and financial metrics to determine whether or not a stock or the market as a whole is either over or undervalued. Unlike technical analysis, fundamental analysis relies on macro and micro-economic trends instead of minute-to-minute price action.

Similar to how traders set up a chart, investors who use fundamental analysis will build financial models to determine the fair value of a stock. This heavily relies on the belief that the market prices assets inefficiently during certain periods.

Fundamental Metrics.

There are various fundamental indicators an investor can use to identify whether or not a business is fairly valued. Though, every industry will be valued differently depending on the growth and maturity.

Price-to-earnings (P/E): Measures the market capitalization to the earnings/profits of the company. Usually, 10 to 30 is best.

Price-to-sales (P/S): Measures the market capitalization to the revenue/sales of the company. Usually, 1 to 5 is best.

Return on Invested Capital (ROIC): The return on invested capital using excess cash. Operating Cash Flow: The amount of cash being placed into the bank from business operations.

Using these metrics, investors can spot hidden opportunities in the stock market. Some investors may notice a high P/E or P/S multiple on a stock, this is directly related to the high expectation that the company behind the stock will grow earnings and revenues at a faster rate on average. However, if the company disappoints investors, the stock can fall substantially following the news.

The higher the ROIC and operating cash flow, the better. Investors who invest based on fundamental analysis want to see consistent returns on capital and operating cash flow growth as they are signs of a healthy company. These two metrics can contribute significantly to earnings/profits later on.