What is Fundamental Analysis?
Fundamental analysis is the analysis, wherein the investment decisions are taken on the basis of the financial strength of the company. There are two approaches to fundamental analysis, viz., E-I-C analysis or the Top Down approach to Fundamental analysis and C-I-E analysis or the Bottom up approach. In the following section, we explain both these approaches.
In the Top down approach, first of all the overall Economy is analyzed to judge the general direction, in which the economy is heading. The direction in which the economy is heading has a bearing on the performance of various industries. That is why Economy analysis is important. The output of the Economy analysis is a list of industries, which should perform well, given the general trend of the economy and also an idea, whether to invest or not in the given economic conditions.
Measuring a Company’s Financial Health
Gaining a true picture of a company’s finances means not only scrutinizing the financial statements but also analyzing relationships among various assets and liabilities, thus highlighting trends in a company’s performance and changes in its financial strength relative to its competitors.
This section explains how to read a company’s financial statements. Measures of value :
Book value is based on historical costs, not current values, but can provide an important measure of the relative value of a company over time. Book value can be figured as assets minus liabilities, or assets minus liabilities and intangible items such as goodwill; either way, the figure that results is the company’s net book value. This is contrasted with its market capitalization, or total share price value, which is calculated by multiplying the outstanding shares by their current market price.
You can also compare a company’s market value to its book value on a per-share basis. Divide book value by the number of shares outstanding to get book value per share and compare the result to the current stock price to help determine if the company’s stock is fairly valued. Most stocks trade above book value because investors believe that the company will grow and the value of its shares will, too. When book value per share is higher than the current share price, a company’s stock may be undervalued and a bargain to investors. In fact, the company itself may be a bargain, and hence a takeover target.
Price/earnings ratio (P/E) is the more common yardstick of a company’s value. It is the current stock price divided by the earnings per share for the past year. For example, a stock selling for $20 with earnings of $2 per share has a P/E of 10. While there’s no set rule as to what’s a good P/E, a low P/E is generally considered good because it may mean that the stock price has not risen to reflect its earning power. A high P/E, on the other hand, may reflect an overpriced stock or decreasing earnings. As with all of these ratios, however, it’s important to compare a company’s ratio to the ratios of other companies in the same industry.
A measure of solvency
Debt-to-equity ratio provides a measure of a company’s debt level. It is calculated by dividing total liabilities by shareholders’ equity. A ratio of 1-to-2 or lower indicates that a company has relatively little debt. Ratios vary, however, depending on a company’s size and its industry, so compare a company’s financial ratios with those of its industry peers before drawing conclusions.
Measures of liquidity
Current ratio. Current assets divided by current liabilities yields the current ratio, a measure of a company’s liquidity, or its ability to meet current debts. The higher the ratio, the greater the liquidity. As a rule of thumb, a healthy company’s current ratio is 2-to-1 or greater.