How to Get Started Analyzing Stocks: Fundamental Analysis

No matter what you do, whether you’re a world class athlete or a beginner writer, you need to master the basics. The reason why basics are so important are because they are the foundation the rest of your knowledge is built upon. The same is true when analyzing stocks. When trying to determine whether a company is solid or not, you need to use fundamental analysis.

Fundamental Analysis for the Long Term

Fundamental analysis follows one of the two main schools of thought regarding how you should analyze stocks. The other is technical analysis. Technical analysis is better suited for traders and investing for the short-term. Meanwhile, fundamental analysis is better suited for long-term value investors such as ourselves.

Fundamental analysis is critical for long-term investing because of its inherent nature. That is, a company’s fundamentals dictates simple measures such as profitability and growth. In addition, fundamental analysis can tell you just how healthy a company is. In other words, fundamentals will cover all of the things that  keep a company thriving for a long time.

What to Look for in a Stock

We talk a lot about healthy companies on this blog. However, what constitutes a healthy company? Well, there are a few simple, fundamental measures to look for. To find them, make sure you check each one of the income statement, balance sheet, and cash flow statement!

First, a company should have a consistently positive net income. You can find net income on the income statement. The primary function of a business is to make money. Therefore, they should consistently be making profits. If they have a year or two in the negative, that is a big red flag. Likewise, if they are constantly in the negative, stay away. Thinking that they will eventually be profitable is gambling, something we don’t do.

Another thing to look out for is growth in net income. Good, strong companies tend to grow their net income year over year. You want to look at 5-10 years of net income and see an upward trend.

Second, a company shouldn’t be overburdened with debt. Look at a company’s balance sheet and look at their total liabilities. Compare this to both their assets and their shareholder’s equity. A healthy company should have more assets than liabilities, and hopefully more shareholder’s equity.

Finally, check the cash flow statement for free cash flow. Here, you can see a company’s operating cash flow. Again, you want this to be positive. Cash is the money a company has on hand right now. This is reflected as cash from operating activities. Make sure you subtract capital expenditures to determine free cash flow!

If a company has a lot of cash on hand, that means they are doing a good job of retaining their earnings. In addition, it’s always nice to have a big pile of cash to dip into when things get rough!

Ratios to Look For

As value investors, finding a healthy company is  only half the battle. We also need to find companies that are undervalued. Therefore, the first ratio, the price to earnings ratio, helps us find undervalued companies.

The price to earnings ratio shows you the price of a stock in relation to how profitable it is. If the P/E ratio isn’t shown, that means the company has negative earnings. Stay away!

On the other hand, we want a low P/E as value investors. Under 15 is worthwhile, while under 10 is great!

When looking at debt, take the total liabilities and divide it by the shareholder’s equity. Hopefully, you find something with a 0.5 debt to equity ratio or lower. Under 1 is still acceptable, but not quite as good. Keeping a low debt to equity helps avoid value traps!

Another great ratio to look at a company’s debt is the current ratio. The current ratio helps you determine how quickly a company could pay down its short-term debt. The current ratio is simply the current assets, divided by the current liabilities. Both of these can be found on the balance sheet. Benjamin Graham states that a current ratio should be 2 or lower.

Final Thoughts on Fundamental Analysis

Fundamental analysis takes into account the most basic indicators of a healthy company. Using fundamental analysis can give you a good picture of whether a company is making money and poised to stay afloat.

This post has touched on just a few of the things you should look for when analyzing stocks. There are many more indicators to look for, that we will discuss later!

If you are interested  in fundamental analysis, try signing up to our Insider’s List. If you do, you’ll receive a free cheat sheet with all of the fundamentals we look for when eye-testing a stock!

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