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What is Fundamental Analysis?

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Following our “Spotting True Value on the Market” blog  , here are some more indepth tips on how to conduct Funamental Analysis.

Qualitative and Quantitative

The factors determined through fundamental analysis can be grouped into two categories, which ar quantitative and qualitative:

  • Quantitative – capable of being measured or expressed in numerical terms
  • Qualitative – related to or based on the quality or character of something, often as opposed to its size or quantity

For the purpose of fundamental analysis, quantitative data includes numeric, measurable characteristics about a business. Financial statements being the biggest source of quantitative data: you can measure revenue, profit, assets and more with great precision.

Qualitative fundamentals attempts to measure less tangible factors such as the quality of a company’s board members and key executives, its brand recognition and patents of proprietary technology.

4 qualitative questions to consider when choosing the right stock for you

There are so many questions you can ask when applying fundamental analysis for a long term investment so I have outlined eight that I think are the most important in the initial stages:

1. Do you understand what the company does

Many of the world’s best investors do not invest in a company they don’t understand. A good place to start is to look at different market sectors such as media, mining, finance and health care. Decide which sectors you understand or are you are interested in and then narrow your the focus.

2. How long has the company been listed on the stock exchange
This a question typically asked by Warren Buffett. He typically considers only companies that have been around for at least 10 years. Fundamental/value investing is based around longevity so it is no wonder that it is one of Buffet’s criteria. In essence, fundamental investing focuses on companies that have stood the test of time but that are currently undervalued.

Historical performance can demonstrate a company’s ability (or inability) to increase shareholder value. Do keep in mind, the past performance of a stock does not guarantee future performance

3. Does the company have a unique product or service?

This is a question that looks at a company’s unique proposition and whether its products are indistinguishable from those of competitors. Any characteristic that is hard to replicate is a competitive advantage. The wider the moat, the tougher it is for a competitor to gain market share

4. Do the company’s products rely on a commodity?
Buffett also asks whether the company is dependent on a commodity such as oil and gas. The reason being, it may be affected by sudden price increases, which in turn may affect a company’s margins.

6 Quantitative Questions to consider when choosing a stock

Ratios, Ratios, Ratios and more Ratios

1. Are profit margins high? Are they increasing?

The profitability of a company depends not only on having a good profit margin but also on consistently increasing this profit margin. This margin is calculated by dividing net income by net sales. To get a good indication of historical profit margins, look back at least five years.

A high profit margin indicates the company is executing its business well, but increasing margins means management has been extremely efficient and successful at controlling expenses.

2. Earnings Per Share

EPS is the profit that a company has made over the last year divided by how many shares are on the market. There is not need to calculate this number yourself because it will usually be given by any financial website or source such as the Australian Financial Review.

3. Price To Earnings Ratio

The best known investment valuation indicater is price/earnings ratio (P/E). The P/E ratio has its imperfections, but it is nevertheless the most widely reported and used valuation by investment professionals and the investing public. A high P/E ratio means investors are paying more for today’s earnings in anticipation of future earnings growth. The basic formula for calculating the P/E ratio is fairly standard.

4. Debt To Equity Ratio

This ratio answers the question “does the company has excess debt or not?” The debt/equity ratio is another key characteristic Buffett considers carefully. It is preferred that the company holds a small amount of debt so that earnings growth is being generated from shareholders’ equity as opposed to borrowed money.  A higher level of debt compared to equity can result in volatile earnings and large interest expenses.

5. Return on Equity

This ratio answers the question, “has the company consistently performed well?” Sometimes return on equity (ROE) is referred to as “stockholder’s return on investment”. It reveals the rate at which shareholders are earning income on their shares. It is used to see whether or not a company has consistently performed well in comparison to other companies in the same industry.

6. Dividend Yield

A stock’s dividend yield is expressed as an annual percentage and is calculated as the company’s annual cash dividend per share divided by the current price of the stock. The dividend yield is found in the stock quotes of dividend-paying companies. Investors should note that stock quotes record the per share dollar amount of a company’s latest quarterly declared dividend. In this example the $1 dividend and $67.44 share price creates a 1.48% yield.

Sources of Company Information

When you start looking you will find company information everywhere.

There great paid newsletters and site out there with the view of top researchers and analysts.

If you are trading yourself usually your online broker should provide access to various information and sources. If you are receiving advice from your advisor they should provide you with research and company information. Otherwise, the following are some good sources of information and great places to start.

Please email us hello@theinvestmentstylist.com.au, if you have any questions or even better let us know where you gather your company information from.

Happy Investing.