What is Fundamental Analysis?

Soultrader · August 27, 2006

It's important to understand the difference between fundamental analysis and technical analysis. A quick explanation is: fundamental analysis focuses on the company and economic events while technical analysis focuses primarily on price action and market behavior.

Fundamentals include earnings report, dividends, sales, inventories, profit margins, P/E ratio, market share, etc....

Technicals include chart patterns, % change, new highs/lows, breakouts, etc...

In this thread I"ll be explaining some of the important information for fundamental analysis. While the TRIN, TICK, PC ratio, prem, tape,etc... all give clues about the health of the market, fundamentals provides us information on the health of the company and its sector.

Let's go over a few key data.

1. Market capitalization: number of shares outstanding x share price

This data gives us an idea of the company size. Companies are classified according to its size: small-cap, mid-cap, and large-cap.

2. EPS: Net income or earnings of the company / number of shares outstanding

This data shows us the profitability of a company.

3. P/E Ratio: Last trade price / earnings per share

One of the most important piece of information to determine whether a company is overvalued or undervalued. Useful number to compare the P/E ratio to other companies. A high P/E ration indicates an overvalued company. A low P/E ration indicates a undervalue company. It is important to compare the company you are analyzing to different companies in the same sector.

Other fundamental tools: revenue, price-to-sales, R&D, debt/equity, management effectiveness ratios, cash flow from operations, etc...

When analyzing the company it is important to ask several questions: What type of business is the company in? How do they earn profits? Does the company profit in during an economic expansion or decline? These are just a few questions you need to ask yourself when analyzing a company. For example, oil companies profit when oil prices are high while airline companies struggle with high oil prices. Home building companies do well during an economic expansion because consumers will look to build new homes. During a recession, a company such as Home Depot may profit because consumers can not afford to spend money on a new home and will look for renovation instead.

Identifying Market Share: industry leaders

Picture the sector of the company as a pie. Whoever owns a bigger piece has a bigger market share. A smaller company will have more difficulties competing with a company that holds the majority of market share.

Look to see the rank of your company within the sector. IBO or Investor's Business Daily is a good place for research market leaders and sector strength.

Insider Transactions

Insider buying and selling must be reported to the SEC so this information is readily available to the public. It is always good to know that the CEO of a company has just purchased shares of its company. Why? These people are in the front lines of the company and hold information that the public does not know. If for example, the president, chairman, and directors are selling a significant amount of shares this can indicate a fundamental problem in the company. However, if the selling is small do not be alarmed. They may be selling shares to purchase a new home, new car, or paying for their children's education.

Generally, you would prefer to own a stock with insiders owning shares. Afterall, an insider with a large stake in his company is likely to run a company more efficiently than an insider with no stake in his company.

Analyst Ratings

I personally do not pay much attention to analysts ratings. Instead I prefer to do my own research. Here is a ranking of stocks:

1. Strong buy: Indicates a company that will outperform that market over the next 1-2 years.

2. Buy: Indicates a company stock prices will rise

3. Attractive: Indicates a stock in good value

4. Accumulate: Indicates an uptrending stock. Analysts recommend investors to buy on the pullbacks.

5. Market outperform: Indicates a stock that outperform the S&P 500

6. Market perform: Indicates a stock to perform similar to the S&P 500

7. Market underperform: Indicates a stock to perform less than the S&P 500

8. Hold: Analysts would not recommend adding new shares. If an investor owns shares in his portfolio an analyst recommends to hold.

9. Avoid: Analyst does not recommend adding any new shares

10. Sell: Analyst is very negative about a company and recommends a sell

11. Strong Sell: Indicates a strong fundamental problem with the company.

One important thing to understand is that the analyst maintains a relationship with the company. Many analysts will not issue a sell rating because this will affect their relationship. Instead they may downgrade a stock from market outperform to market perform. Issuing a sell rating may hurt the brokerage firm and companies future business relationship.

All publicly traded companies are required to submit a financial statement called the 10-Q and 10-K by the SEC. A good site for resource is 10k Wizard: SEC Filings or EDGARfilings - SEC EDGAR Filing Software and Outsourced Services. You can also request additional information at the companies investor relations department.

Book Recommendation:

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