What Are the Fundamentals of a Stock?
A stock’s fundamentals are the factors that are thought to contribute to the underlying company’s value or worth as a business. Fundamentals can include measurable, quantitative data (like cash flow and debt-to-equity ratio) and qualitative, situational factors (like business model and competitive advantage). The most common quantitative metrics and qualitative factors that make up a company’s fundamentals are listed later in this article.
What Is Fundamental Analysis?
Fundamental analysis is the process of examining all of a company’s fundamentals, both quantitative and qualitative, to determine the “real” or intrinsic value of a stock. This value can then be compared to the price the stock is currently trading at to make strategic investment decisions.
What Is the Main Assumption of Fundamental Analysis?
Traders who use fundamental analysis assume that the market does not always value all stocks accurately. This is antithetical to the efficient market hypothesis, which assumes all stocks are accurately valued at all times (more on this below).
What Is Fundamental Analysis Used For?
Investors and institutions often use fundamental analysis to get a more accurate picture of a company’s intrinsic value. Here, intrinsic value refers to the “true” worth of a company (rather than its market value) based on the many factors that contribute to its health and success.
Investors who prefer fundamental analysis to technical analysis believe that the price of a company’s stock isn’t always an accurate gauge of the company’s value. By conducting fundamental analysis, an investor can identify a stock they believe is undervalued by the market and choose to invest in it with the hope that it will rise in price in the long term as the company’s value becomes apparent to the market over time. Similarly, an investor could choose to sell a stock they’ve been holding that has gone up in price because fundamental analysis tells them that it is now overvalued by the market.
How Does Fundamental Analysis Differ From Technical Analysis?
As mentioned above, fundamental analysis is based on the assumption that the market doesn’t always accurately value all stocks. Traders who use the technique try to identify and purchase companies that are undervalued with the expectation that they will eventually trade higher as the market at large recognizes their worth.
Technical analysis, on the other hand, is the process of making trading decisions by evaluating price trends and patterns rather than examining a company’s fundamentals. This technique is based on the “efficient market” hypothesis, which assumes that a company’s fundamentals directly inform the price its stock trades at because all relevant information is always available to all traders.
From the standpoint of the efficient market hypothesis, fundamental analysis is unnecessary, as all stocks are accurately valued at all times, so trading decisions are best made based on trend evaluation and pattern recognition. Traders who use technical analysis spend much of their research time looking at graphs, charts, and historical data to make predictions rather than evaluating company-specific metrics like cash flow and earnings growth.
What Are the Quantitative Components of a Stock’s Fundamentals?
Many important fundamentals are publicly available quantitative metrics that can be compared between stocks within an industry. (Comparing quantitative fundamentals between stocks in different industries provides less insight, as different industries have different norms.) Below are some of the most common quantitative metrics used in fundamental analysis.
Earnings per Share (EPS)
Earnings per share is a metric that expresses a company’s annual profit, less dividends paid, per share of its stock. To calculate EPS, a company’s net income after dividends is divided by the total number of shares outstanding.
EPS = (Earnings – Dividends) / Number of Shares Outstanding
Price-to-Earnings (P/E) Ratio
The price-to-earnings ratio is a metric that expresses the current price of a share of a company’s stock in terms of its EPS (earnings per share). It is essentially the price investors pay for one dollar of earnings per year. To calculate this metric, share price is divided by annual earnings per share.
P/E Ratio = Share Price / Earnings per Share
Price-to-Sales (P/S) Ratio
The price-to-sales ratio compares a company’s share price to its annual sales (revenue). This metric does not take profit (earnings) into account. To calculate this metric, share price is divided by annual sales per share.
TheStreet Dictionary Terms
P/S Ratio = Share Price / Sales per Share
Price-to-Book (P/B) Ratio
The price-to-book ratio compares a company’s market value (market cap) to its book value (assets minus liabilities). To calculate this metric, share price is divided by book value per share.
P/B Ratio = Share Price / Book Value per Share
Debt-to-Equity (D/E) Ratio
The debt-to-equity ratio compares a company’s liabilities (debt) to its shareholder equity to determine the degree to which its operations are funded internally vs. externally. To calculate this metric, a company’s total liabilities are divided by its shareholders’ equity.
D/E Ratio = Liabilities / Shareholder Equity
Projected Earnings Growth (PEG) Ratio
The projected earnings growth ratio compares a company’s price-to-earnings (P/E ) ratio to its growth rate. To calculate this metric, a company’s P/E ratio is divided by its growth rate (as a whole number percentage).
PEG Ratio = P/E Ratio / Growth Rate
Free Cash Flow (FCF)
Free cash flow is essentially the cash brought in by a company’s operations minus the cash it spends to support those operations and maintain its assets. This metric takes into account any changes to working capital.
Dividend yield is a metric that expresses the percentage of a company’s stock price that is paid out annually to each shareholder in dividends. To calculate this metric, annual dividends paid per share are divided by the current share price.
Dividend Yield = Dividends Paid Per Share / Share Price
Dividend Payout Ratio
The dividend payout ratio is the percentage of income a company passes on to its shareholders in the form of dividends. This metric is calculated by dividing the total amount of dividends paid by a company’s total earnings (income).
Dividend Payout Ratio = Dividends Paid / Income
Return on Equity (ROE)
Return on equity compares a company’s income to its shareholders’ equity. This metric is calculated by dividing a company’s net income by its average shareholder equity during the period in question.
ROE = Net Income / Shareholder Equity
What Are the Qualitative Components of a Stock’s Fundamentals?
While clearly defined quantitative metrics are important and give investors a common language through which to compare companies in a given industry, fundamentals comprise more than just numbers. When examining a company’s fundamentals, less measurable but equally important factors must also be considered. Below are a few of the most important.
A company’s business model is the method it uses to make profit. Similar companies may employ different business models despite providing similar products or services, and some investors may see more merit in some models than others when it comes to the value of a business. How does this company operate?
Within a particular industry, some businesses may have advantages that others don’t. Whether that’s access to a particular technology, a well-established distribution network, or something else, investors can look for factors that they think might make one business more likely to succeed than others. What does this business have that similar businesses don’t?
While some of a company’s operations may be automated, management staff are responsible for research, growth, innovation, company image, strategy modifications, and other important work that directly contributes to a company’s success. Who are the people at the helm of this business?
Corporate Policies and Ethics
The way a company interacts with its employees, the public, other companies, governments, and regulatory agencies can offer investors insight into the company’s values and ethical merits. These factors can also influence how a business is perceived in its community. Is this company communicative and transparent with the public and its shareholders?
Microeconomic factors like supply and demand within a particular industry or market can affect a business’s success. For instance, if the raw materials a company uses to manufacture their products are in short supply, the prices of their products may increase, which could affect their profits. What’s going on with consumers, markets, and the industry that could affect this company’s operations?
Macroeconomic factors that affect entire countries (like inflation rates and market crashes) can also affect individual businesses and their shareholders. What large-scale phenomena are at play that could affect this company’s value?
Frequently Asked Questions (FAQ)
Below are answers to some of the most common questions investors ask about company fundamentals.
What Do Strong Fundamentals Look Like?
Fundamentals—especially quantitative fundamentals—vary quite a bit between industries. What’s considered normal in aerospace is understandably very different from what's considered normal in agriculture. That being said, there are a few factors that likely indicate strong fundamentals regardless of industry. A company with very good fundamentals would likely have more than enough cash for operations, little debt, strong leadership, good brand recognition, and a solid track record of growth.
How Well Do Fundamentals Predict Stock Price?
In a so-called “efficient market,” companies would trade at their exact worth, which would, in theory, be based on their fundamentals. In reality, however, fundamentals are just one of several factors that go into a stock’s market price. In many cases, a stock’s market price is the result not only of its fundamentals, but also of technical factors (like inflation, investor interest, and market trends) and market sentiment (large-scale investor psychology based on news and other factors).
Where Can You Find a Company’s Fundamentals?
A company’s quantitative fundamentals can be calculated using publicly available information released in quarterly or annual statements and reports. In many cases, quantitative fundamentals can also be found simply by searching a company’s name followed by the metric in question (e.g., “Apple P/E ratio”) on the internet. Qualitative fundamentals are more subjective, so each investor must evaluate them for themself by sifting through news, company websites, and any other information they can find.