Fundamental Analysis

Fundamental analysis is a method of evaluating a security that entails attempting to measure its intrinsic value by examining related economic, financial and other qualitative and quantitative factors. Fundamental analysts attempt to study everything that can affect the security's value, including macroeconomic factors (like the overall economy and industry conditions) and company-specific factors (like financial condition and management). The end goal of performing fundamental analysis is to produce a value that an investor can compare with the security's current price, with the aim of figuring out what sort of position to take with that security (underpriced = buy, overpriced = sell or short).

Since the financial markets are all about supply and demand, one must ask themselves what they believe other investors are looking for in a company in which to invest. In most cases the answer will be one or a combination of the following; growth, stability, dividend payout, and sustainability of same. A trader could exhaust hours on each trading candidate leaving themselves little time for actual trading so we are going to try and simplify the process for you. Here are the key ingredients when conducting your fundamental due diligence on a company:

Market Cap

Market Cap is essentially the value of the company based on the number of shares outstanding and the price per share. Companies are broken into categories based on their total value.

  • Mega-cap: Over $200 billion
  • Large-cap: Over $5 billion
  • Mid-cap: $1 billion-$5 billion
  • Small-cap: $250 million-$1 billion
  • Micro-cap: Below $250 million
  • Nano-cap: Below $50 million

Implied risk moves up as market cap goes down.

Optionable

Not all stocks offer options on them. At last check, over 3,000 companies offered options on their shares, so there is plenty to choose from.

P/E Ratio

This is the price of the stock divided by the earnings per share. The lower the P/E, the less you are paying for the company. High P/E stocks are considered more speculative in nature. Every P/E should be compared to the P/E of the S&P 500 and to its nearest competitors. P/Es should also be view in light of their historic figures to determine when the price might be getting too speculative in nature.

Forward P/E

This is the projected P/E for the next fiscal year. If this number is lower than the current P/E, this means that earnings are forecasted to be higher in the coming year. If the forward P/E is greater than the current P/E, this indicates that earning are expected to drop for the next fiscal year. This could cause the price of the stock to drop in the future unless management is able to sustain current profit levels.

Sales Growth

This is known as top line revenue. Is the company expanding or contracting? A slow down in the sales number should be a red flag for the potential of lower future earnings.

Long Term Debt to Equity

This figure allows the fundamental analyst to determine how leveraged or debt laden the company is at the present time.

Current Ratio

The ratio is mainly used to give an idea of the company's ability to pay back its short-term liabilities (debt and payables) with its short-term assets (cash, inventory, receivables). The higher the current ratio, the more capable the company is of paying its obligations. A ratio under 1 suggests that the company might be unable to pay off its obligations if they came due at that point.

Institutional Ownership

Institutional ownership refers to the ownership stake in a company that is held by large financial organizations; mutual funds, insurance companies, pension funds or endowments. Since these organizations buy shares in large blocks, they are the primary reason for the movement in the price of a security. Strong institutional support is important in driving the price of a stock higher.

Insider Transactions

The SEC considers insiders to be company directors, officials or any individual with a stake of 10% or more in the company. Insiders are required to report their insider transactions within two business days of the date the transaction occurred. Their activities are a matter of public record. When insiders are purchasing stock in their company, this is considered a positive sign as these individuals are in the best position to know what is really happening inside the organization. Conversely, when they start unloading their shares it could be a sign that they believe that the future price will decline. Please note that insiders may be selling for personal reasons unrelated to their confidence in the company. That being said, insider buying is considered bullish, whereas, insider selling is viewed as bearish.

Profit Margin

This figure represents how much a company actually makes when they sell a product/service, after expenses. High profit margins allow a company more flexibility in their pricing model as they can discount, when needed, and still turn a profit. Profit margins will vary from sector to sector. Margins may be very high in the technology sector but very low in the food business, for example.

Return on Equity

This is the amount of net income returned as a percentage of shareholders equity. Return on equity measures a corporation's profitability by revealing how much profit a company generates with the money shareholders have invested. It is calculated as follows: net income/shareholder's equity.

Dividend Yield

This figure is equal to the annual dividends paid by the company divided by the price per share of the stock. Certain sectors generally pay a higher dividend than others. For example, a utility company will normally pay a higher dividend than a small growth company. Many companies pay no dividends at all. Dividends are of greater importance to investors when interest rates on banking instruments are low. Investors will take money from their savings to purchase shares of a company with a dividend that is higher (in percentage terms) than the interest rate offered by their financial institution. When the market is volatile, investors will flock to higher dividend paying stocks as a way to offset some of the risk in the market. The dividend is viewed as a cushion against falling stock prices.

Analysts Ratings

Research analysts study companies and draw on a wealth of industry, economic, and business trend information to help their clients make better investment decisions. Some analysts are unaffiliated: they sell their independent research to financial or investing institutions, banks, insurance companies, or private investors on a project or subscription basis. But a large number of analysts are employed by institutions whose financial stake in their recommendations may go well beyond their accuracy. Other analysts work for institutional money managers, such as mutual funds, hedge funds, or investment advisers.

Understanding the significance of analysts recommendations is a little tricky in that they historically are bullish on a huge percentage of equities, and by the time they give a sell signal, the stock may have already dropped substantially. That noted, it is worthwhile to see if analysts are upgrading or downgrading a particular stock as their opinion carries some weight in the marketplace, particularly with institutional investors. It is also interesting to review their price target on a stock in which you may be considering placing a trade.

News

Good or bad news can move the price of a stock faster than any other single piece of fundamental analysis. For this important segment, we will break news into five distinct categories:

Internal Developments: Developments that can occur within companies will affect the price of its stock, including mergers and acquisitions, earnings reports, the suspension of dividends, the development or approval of a new innovative product, the hiring or firing of company executives and allegations of fraud or negligence. Stock price movements will be most drastic when these internal developments are unexpected.

US Economy:

Perhaps the most important indicator of the health of the economy is employment. On the first Friday of each month, the U.S. Bureau of Labor and Statistics releases its monthly unemployment report and non farm payroll; these indicate the current unemployment and how many jobs have been gained or lost by the U.S. economy.

One of the most popular ways is to measure market sentiment is through consumer confidence. There are several measures of consumer confidence; all are designed to determine how consumers feel about their economic prospects in the coming months. The theory is that when consumers feel more confident, they are more likely to spend; conversely, they are less likely to spend when they feel less confident. Also, because markets are forward looking, there is a tendency for stock prices to reflect the future opinions of consumers today.

The housing market serves as another vital economic indicator. Although housing is highly localized and difficult to measure on a national basis, there are several indicators that do a reasonable job. Market participants pay attention to monthly releases such as housing starts, building permits and new home sales in order to get a reading on the level of activity in the housing market.

World Economy

It used to be than investors only needed to concern themselves with US economic data when investing in domestic securities. In the last couple of decades, however, the world has morphed into a global economy where the nations are now finically interdependent. Since most major US companies sell around the world, demand for their products will ebb and flow with the health of each of their trading partner nations. These days, investors better know as much about what's happening in Europe and China as they do with respect to what's happening at home.

World Events: Company stock prices and the stock market in general can be affected by world events such as war and civil unrest, natural disasters and terrorism. These influences can be direct and indirect, and they often occur in chain reactions.

Inflation and Interest Rates: One of the more predictable influences of the stock market are periodic adjustments of interest rates by the U.S. Federal Reserve to combat inflation. When interest rates are raised, many investors sell or trade their higher risk stocks for government-backed securities such as bonds to take advantage of the higher interest rates they yield and to ensure that their investments are protected.

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