Fundamental analysis
Fundamental analysis: what is the right price for a stock?
Fundamental analysis is a methodology used to identify investment and trading opportunities by analyzing trends and focusing on patterns. Investors use fundamental analysis to calculate the true underlying value of a stock. Using key figures published by companies, you can calculate financial ratios to determine whether a company's stock is a profitable investment or not.
These figures typically come from three separate but interconnected reports that a publicly traded company publishes for its investors in quarterly or annual reports: the balance sheet, the income statement, and the cash flow statement.
The balance sheet summarizes a company's assets (the resources that have economic value to the company), liabilities (the debts the company must repay), and equity (the company's net worth). The formula that links these three aspects of a company is:
The income statement (also known as the profit and loss statement) complements the balance sheet in an annual report. It shows the company's revenues and expenses over a given period. The key figures in the income statement are sales (or revenue), profit, and earnings per share.
Finally, the cash flow statement examines all cash inflows and outflows of the company. Although similar to the income statement mentioned above, the cash flow statement is not actually a performance report, but rather an accounting history. Cash flows generally come from three areas of the company: operating, investing, and financing.
These three documents are usually found in the company's annual report. This report is publicly available to maintain transparency with shareholders about the state of operations. Some more sophisticated models also take into account external factors, such as macroeconomic conditions or tax policy. However, for this introduction, we will limit our analysis to company data.
Key financial ratios in the stock market
There is a wealth of information about publicly traded companies that can be easily found online. Some of these figures (such as number of employees, revenue, and profit) are fairly self-explanatory. But there are also more complex financial figures and ratios, each designed to assess various aspects of a company's performance and financial health. Below are the ones most commonly analyzed by investors.
Market capitalization of a company
What is market capitalization?
Market capitalization is the total value of a company's outstanding shares at a given time.
How to calculate market capitalization?
This indicator is important in determining whether a company is classified as large, mid, or small cap. Large-cap companies are often considered companies with a market capitalization greater than $10 billion. Mid-cap companies have a market capitalization between $2 billion and $10 billion. Finally, small-cap companies have a market capitalization between $300 million and $2 billion.
For example, as of June 15, 2021, Apple's market capitalization was €2.177 trillion, and Amazon's was €1.707 trillion.
Earnings Per Share (EPS): earnings per share
What is earnings per share?
Earnings per share (EPS) is the amount of profit a company earns per outstanding share. As the name suggests, it represents the total value each share contributes to the company. An EPS of €5 means that each issued share generates €5 in net income for the company.
How to calculate earnings per share?
How to analyze earnings per share?
High earnings per share (EPS) is a sign of high profits for the company in question. However, since there is no general benchmark, earnings per share (EPS) can be interpreted in various ways. To obtain more meaningful results, a long-term analysis is necessary to determine the company's earnings capacity over time. It is also important to make comparisons with the earnings per share of other companies in the same industry .
Dividend per share
What is dividend per share?
Dividend per share (EPS) is a financial ratio that aims to determine, through a simple calculation, a company's earnings power. Dividend per share is the amount of dividend paid per share.
How to calculate dividend per share?
For example, LVMH paid a dividend of 6 euros per share for 2020. Apple, for its part, paid a dividend of 2,615 dollars per share in the same year.
The Price Earnings Ratio (PER)
What does PER mean on the stock market?
The Price Earnings Ratio (or Price/Earnings Ratio) is one of the most widely used financial ratios. The PER is expressed as a multiple of a company's stock price over its earnings per share (EPS). Thus, the Price Earnings Ratio is also known as the price multiple. It expresses the number of years of earnings that an investor is willing to pay when purchasing a stock.
How to calculate the PER on the stock market?
For example, if a company's share price is 10 euros and the calculated earnings per share are 2 euros, the company's Price Earnings Ratio is 5.
Return On Equity (ROE): profitability of equity
The last of the key figures is return on equity. ROE is the ratio of net income to outstanding equity. It shows the profitability (earning capacity) of a company generated by invested capital.
How to calculate return on equity?
For example, if a company's total net income is €10 million in a year when its equity is €25 million, its return on equity will be 40%.
How to analyze the rate of return on equity?
As with other financial ratios, it is best to analyze a company's Return on Equity over time and compare it to that of companies in the same industry. If a company's return on equity rate increases over time, then the company is becoming more efficient (higher profits with less invested capital).
Limits of fundamental analysis
Fundamental analysis is a method, but it has its limitations. One of these is the fact that the Efficient Market Hypothesis (EMH) contradicts this method. This economic principle states that market prices reflect past information. Therefore, there is no benefit to analyzing trends by focusing on patterns. Adding to this is the self-fulfilling aspect of fundamental analysis. Indeed, when a large number of investors use the same signals and data to decide which stocks to buy, these stocks themselves can cause the expected movement. This will then create a snowball effect.
Finally, it's important to understand how fundamental analysis works before applying these principles to your investment decisions to avoid potential losses. It's therefore necessary to experiment with a number of strategies and use a combination of indicators to achieve significant trading results. At PHH Solutions, we are open and transparent about the risks associated with investing.
Before you start investing, there are several factors to consider. It's helpful to think about the level of risk you're willing to take and which products are best suited to your level of expertise. It's also not advisable to invest money you might need in the short term or take positions that could lead to financial hardship. It all starts with thinking about the type of investor you want to be. You can find more information about the risks involved in investing by reviewing our investment services disclosure documents or on our dedicated investment risks page.
The information in this article is not intended as advice or investment recommendations. Investing involves risks. You may lose (part of) your deposit. We recommend that you only invest in financial products that match your knowledge and experience.