1. Invest-Safely.com
    2. >>
  2. How to Start Investing
    3. >>
  3. Fundamental Analysis Techniques

Use Fundamental Analysis Techniques to Estimate the true "Value" of an Investment

Fundamental analysis techniques are calculations that try to estimate the "true" value of an investment based current financial data. For stocks, the corporate financial statements contain most of the info you'll need. For other investments, like bonds or commodities, fundamental analysis techniques can include macroeconomic factors such as global, national, and industrial outlooks, interest rates, and inflation.

The goal is to compare the "true" value of an investment with the current market value, and find investments that are mispriced.

When the "true" value is lower than the current market price, an investment is "overvalued". This means meaning that price is too high, and investors should consider selling (or at least not buying). If the "true" value is higher than the current market price, an investor would say the investment was "undervalued", which is a buying opportunity.

Warren Buffet's success with this type of analysis is well-publicized, and he is considered to be one of, if not the best fundamental investors.

Key Ratios for Stocks

Financial

  • Sales
  • EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization)
  • Net Income
  • EPS
  • Dividend/Share
  • Debt/Equity
Valuation
  • Price/Earnings (P/E Ratio)
  • Price/Book Value
  • Price/Sales
  • Price/Cashflow
Profitability
  • Return on Equity (ROE)
  • Return on Assets (ROA)
  • Operating Margin
  • Net Margin

Why Use Fundamental Analysis Techniques?

The price of an investment, over a long period of time, tends to be driven by fundamental factors, making fundamental analysis a useful tool for assessing potential long-term value.

And in the U.S., generally Accepted Accounting Practices (GAAP) allow investors to calculate and compare financial information for different companies, making relative judgements possible.

That said, prices can fluctuate quite a bit in the short-term, because they're impacted by more than just fundamental information. For instance, even investments with superior fundamentals can fall in price and lose money for investors during a market correction or recession.

And standard accounting practices don't stop companies from adjusting their reports, which come in the form of "pro-forma" calculations. And there's always a risk that a companies management chooses report false info (i.e. "cook the books").

Example of Fundamental Analysis

There are many sites that provide ratios and other fundamental data. Their pages have done some of the heavy lifting for you. Some of the ratios listed on this page might require that you look at the companies financial statements.

For instance, go to the Yahoo! Finance (Click here to open Yahoo! Finance in a new window) or Marketwatch (Click here to open Marketwatch in a new window) webpages and look up a quote for Microsoft (MSFT).

Check out the different sections and you'll find a lot of the info mentioned above.

The price-to-earnings ratio (P/E Ratio) is one common data point used in fundamental analysis. It's calculated by taking the current market price and dividing it by earnings per share (EPS).

There are usually two flavors of this ratio:

  1. Forware P/E
  2. Trailing 12 months (TTM) P/E

Assume that MSFT stock is currently trading at $25.50, with an EPS over the past year of $1.62 / share. As stated above, the P/E Ratio is calculated by dividing the price per share (25.5) by the earnings per share (1.62). This gives you a P/E Ratio of ~15.74.

Now its time to make some comparisons. Lets assume that Microsoft is part of an industry group that has an average P/E ratio of 20. This means MSFT has a lower P/E ratio than its industry group, meaning that it is undervalued when compared with its peers.

You could also compare a company's P/E ratio with the average for an index, say the S&P500, to see if it's over or under valued compared with the market at large.