If you’re eyeing a company to invest in, you need to know how to evaluate its investment worthiness. There are plenty of evaluation strategies and methods: a key approach is fundamental analysis.
Fundamental analysis is a way of figuring out whether a stock is worth investing in based on how the company is performing as a business and not just how its stock price moves.
The goal of fundamental analysis is to estimate a company’s intrinsic value, assess whether its current stock price looks low, high, or just about right, and then make a decision about whether the stock has potential for long-term, above-average returns.
To perform a fundamental analysis of a company, investors look at:
Company data: things like revenue, profits, assets, and the performance and reputation of the company’s executive leadership.
Industry data: how the company stacks up against competitors, and what trends are shaping the sector it belongs to.
Macroeconomic data: how outside forces such as inflation, interest rates, and consumer demand can affect the business environment in which the company operates.
How fundamental stock analysis works
Fundamental analysis requires data gathering, interpretation, and valuation. You start by collecting and studying company, industry, and macroeconomic data, then interpret what that data says about the company’s performance, financial health, and long-term outlook. Then you make your assessment.
Look at the financial statements
A company’s financial statements are the core of fundamental analysis. They show where the company’s money comes from and how it’s spent.
Common sources of financial statements include a company’s annual and quarterly reports, which are available through SEDAR+ in Canada or the 10-K and 10-Q forms in the U.S. Financial statements can include:
Income statements, which show how much revenue the company brings in and how profitable it is over time. Look for trends in sales growth, operating income, and net profit margins.
Balance sheets, which show what the company owns (its assets) and what it owes (its liabilities), as well as the shareholders’ equity. A balance sheet gives you a sense of how a company finances its operations and growth, and of its financial stability.
Cash flow statement, which tracks how cash actually moves through the business, including operating cash flow (the cash generated by operations) and free cash flow (the cash left after necessary investments). These numbers help you gauge the company’s ability to sustain and grow its operations. They’re usually split into three sections: operating, investing, and financing.
Evaluate key ratios
Once you’ve reviewed the financial statements, you can use financial ratios to compare the company’s current financial health and performance to its history, as well as against its competitors.
Here are some common ratios, and what they can tell you about a company’s financial health.
Ratio | What it indicates |
|---|---|
| Price-to-earnings (P/E). Forward P/E (uses estimates of company’s earnings for next 12 months); Trailing P/E (uses company’s earnings from past 12 months) | Compares a company’s stock price to its earnings per share (EPS), either using current forward P/E or trailing P/E; Indicates how much investors are willing to pay for each dollar of profit; Reflects market expectations for future growth (though it can also represent a bubble) |
| Price-to-book (P/B) | Compares a company’s stock market price per share to its book value per share (net assets on the balance sheet); Helps show whether the market values the company above or below what its assets are worth on paper |
| Return on equity (ROE) / Return on invested capital (ROIC) | Measures how efficiently a company uses shareholders’ equity (ROE) or total invested capital (ROIC) to generate profits; Higher returns usually indicate effective leadership and strong profitability |
| Gross margin / operating margin | Shows how much profit the company keeps from each dollar of sales after covering its costs (gross margin after production costs, operating margin after operating expenses); Indicates how efficiently the company manages its costs and operations |
| Debt-to-equity and interest coverage | Indicate how much the company relies on debt financing (debt-to-equity) and how comfortably it can cover its debt payments (interest coverage); Useful for judging a company’s financial stability |
| Free cash flow (FCF) and FCF yield | Show how much cash the company generates after funding necessary capital investments, and how that cash generation compares to its market value (FCF yield); Indicate how financially flexible a company is |
| Dividend payout / coverage ratios | Measure the sustainability of dividend payments (the payout ratio shows what share of earnings is distributed as dividends; the coverage ratio shows how many times company earnings can cover those dividends); Help show whether the company is generating enough to pay (or increase) its dividends over time |
Consider qualitative factors
The numbers in financial statements and key ratios are the quantitative factors in a fundamental analysis. Qualitative factors can help explain why the numbers are what they are.
Examples:
The business model. How does the company make its money?
Competitive advantages. What are the company’s unique value propositions compared to its competitors
Management and decision-making. Who are the executive leaders, and what are their credentials and reputation? What does the company’s track record of decision-making look like?
Look at the bigger picture
Every company is susceptible to external influences, like macroeconomic trends, industry dynamics, and regulatory changes.
These factors can include:
Interest rates, which affect borrowing costs and valuation levels.
Inflation, which impacts input costs (such as supplies and raw materials) and consumer purchasing power.
Economic cycles, such as recessions or periods of expansion, which influence consumer demand for products and services.
Sector trends, which can help you evaluate whether the company is operating within an environment that’s growing, struggling, or facing emerging challenges.
Valuation methods to estimate intrinsic value
Once you’ve gathered and interpreted both the quantitative and qualitative data, the next step is to estimate what the company is actually worth. This is where valuation methods come in: Discounted cash flow (DCF): estimates what the company’s future cash flows are worth in today’s dollars. It’s a detailed valuation, but it can change a lot depending on the assumptions you make about the company’s growth and what rate you use to discount the future cash amounts.
Comparable multiples (comps): values a company by comparing it to similar companies in the market using ratios like P/E and P/B. This method offers a reality check for how the market values companies in the same sector. Sometimes they can be influenced by general market sentiment and cyclical factors (depending on the sector).
Dividend discount models (DDM): values a company’s stock based on the dividends it’s expected to pay in the future. This method works best for mature, stable companies with consistent payout histories.
Because every model has its limitations, investors often use several valuation methods and then compare the results to see if they point to a similar value (called “triangulating”). This helps build a more well-rounded idea of what a company is truly worth.
Pros and cons of fundamental analysis
Like any investment approach, fundamental analysis has its strengths and weaknesses. Knowing when it’s most useful and where it can fall short can help you use it more effectively.
Pros:
Helps assess the risk, quality, and long-term sustainability of a company
Can inform a comprehensive, long-term view of a company’s value
Encourages investment decisions based on real business performance and cash flows
Cons:
Sensitive to assumption; small changes to quantitative factors can shift results
Differences in how companies report data and account for financials can make them harder to compare
Relies on historical data, while markets often move based on expectations for the future
Can be time-consuming to put together
Only as reliable as the quality of the information used
Quick step-by-step guide: how to analyze a stock using fundamental analysis
Look at the company’s business overview to understand what it does exactly and how it makes money.
Review income statements, balance sheets, and cash flow statements. Look for multiyear trends in growth, profitability, and financial health.
Calculate key ratios (such as margins, ROE, P/E, P/B, and debt-to-equity) and compare them to averages of other companies from the same sector.
Assess the company’s qualitative factors.
Do a quick valuation check. Estimate the company’s value using the comps or by comparing to a ratio like P/E or P/B.
Identify business risks (what could hurt the company’s performance) and test your assumptions (what could change your valuation view).
Continue your research to make a final assessment. You can focus on gaps or uncertainties to help you make a decision about whether or not the company is a solid option for long-term investment, rather than jumping to a buy/sell conclusion.
Fundamental analysis helps you understand a company’s intrinsic value by studying its financial performance, business model, and economic context, not just its stock price movements. And by understanding its intrinsic value, you can make a more confident decision about whether its stock market price makes sense and whether it has potential for above-average returns. But remember: the results of your analysis will depend on the quality of the data you’re using and how solid your assumptions are.
