The stock market functions like a swap meet, auction house, and shopping mall all rolled into one. Purchasing shares of a public company allows you to become a partial owner, and share prices on the exchange can fluctuate up or down.
Conducting fundamental analysis of a stock is a good way to determine whether it is under- or overvalued by the market. There are 2 types of fundamentals: quantitative and qualitative.
1. Intrinsic Value
Fundamental analysis centers around determining a stock’s intrinsic value, or the worth of the company as an investment. Investors like Warren Buffett and others who subscribe to this theory believe that if you can find stocks trading below their intrinsic value, it may be a good idea to invest in them.
While a number of ways to determine intrinsic value exist, professional investors often use discounted cash flow (DCF) to make calculations. This method estimates a company’s future cash flows and subtracts its weighted average cost of capital, which represents the time value of money.
This figure, which includes the company’s debt and operating expenses, will provide a firm estimate of a stock’s true worth. Knowing this can help you avoid overpaying for a stock, as opposed to simply acting on a hunch. However, establishing intrinsic value can be complicated. It requires extensive research into a company’s financial performance, competitive situation and economic conditions. It also relies on projections about the future that can sometimes be inaccurate.
2. Price-to-Earnings (P/E) Ratio
As its name suggests, the P/E ratio measures how much investors are willing to pay per dollar of a company’s earnings. A higher ratio means a stock is more expensive than a lower one.
A common variant of the P/E ratio, sometimes called the forward P/E, is based on future estimates for per-share earnings. This indicator can be useful, but it’s important to remember that projections are subject to a range of factors and can change dramatically.
For instance, a company may be in a cyclical industry, which causes its earnings to fluctuate. Its P/E ratio may rise during a boom, but drop during a bust. This can give the appearance of a cheap stock, even though the intrinsic value didn’t change. To avoid this trap, it’s best to compare the P/E ratio of a company to its peers when making an investment decision. This can be done through a number of online tools, including the thinkorswim platform.
3. Price-to-Book (P/B) Ratio
The price-to-book ratio, or P/B ratio, is a key stock market fundamental that can help investors assess the value of a company. It is calculated by dividing the share price of a company by its book value per share. The book value of a company is its total assets minus its total liabilities, and it can be found by looking at the company’s balance sheet.
The price-to-book ratio is useful for investors who take a value approach to investing, as it can help them identify undervalued stocks. However, it is important to keep in mind that the P/B ratio is only as good as its industry norms, and it may not be indicative of the true value of a company’s assets. For example, the P/B ratio might be high for insurance companies but low for manufacturers who depend on capital equipment and inventory. Therefore, it is best to use the P/B ratio as a part of a comprehensive stock analysis.
4. Dividends
Dividends are payments of cash or additional stock made by public companies to shareholders (aka partial owners) on a regular basis. They are typically issued quarterly, but may be paid monthly or biannually.
A company will choose to pay a dividend if it wants to return some of its profits to shareholders, or if it has excess cash that is not needed to grow the business. Companies that pay a consistent dividend tend to be more stable and conservative in their operations than those that do not, so investors often view them as a safer investment.
Investors who focus on dividend-based investing usually look for companies that have a history of increasing their dividend payouts over time. However, it is important to note that some high-yield dividend stocks may be facing a specific business challenge, so researching them thoroughly before making an investment decision is crucial. Typically, this means working with a financial pro. Moreover, some high-yield stocks may be trading at an elevated valuation and therefore might not be as attractive as they appear on the surface.
