Fundamentals Analysis Explained

Fundamentals analysis is concerned with analyzing the prospects and outlook for a company, and this is often used by investors to determine which shares they should buy. If you are considering trading, then you will find that you do not use fundamental analysis much. When trading, technical analysis is more useful, as it seeks to reflect the current market view on a share’s value, and thus anticipate imminent price changes.

However, fundamental analysis has its place when deciding on long-term investments. Typically, the analysis starts with looking at the company’s accounts. Most of this can be done online, as the figures are available both from the companies themselves and on many financial websites. The figures that are most interesting are those which reveal the company’s potential in the future, as this is what will determine the long-term values.

 

Fundamentals Analysis Explained

As you might expect, sales figures and profit figures dominate fundamental analysis. It is useful to compare previous year’s figures to the current year’s to determine if sales are increasing or decreasing, and how profit levels compare on similar numbers of sales. This can vary if the company has made some efficiencies in production or suffered production setbacks, as even with the same number of units sold the profits may go up or down.

Apart from comparisons of several years, fundamental analysis will often compare different companies which operate in the same field and are of similar size. There are various ways in which this can be done. For instance, one of the fundamental factors often selected is the price-earnings ratio, or P/E ratio. This is typically around 15 for the market as a whole, though the average value varies depending on the market sector. It is calculated from the share price and the declared earnings per share (EPS). For example, if the share price is £100 and the earnings per share on an annual basis were £6 last year, then the P/E ratio would be 100 divided by 6, which works out to 16.7.

Suppose a competing company in the same market sector declared earnings of £4 per share, and the share price was quoted at £55. By calculating the P/E ratio to be 13.75 in this case, you can see that the shares are relatively undervalued compared to the first company.

Other fundamental factors that are significant include the amount of equity tied up in the company, compared to its profits, and the company’s debt ratio, which is how much it owes compared to its value. Once again, there is no standard universal value for these, and some industries regularly use a much higher debt ratio than others. As mentioned above, a good way to gauge the significance of any numbers is to compare them with those of similar companies in the same business.

As mentioned in the beginning, these factors are not worth mentioning if you are interested in trading rather than investing, even though it is a good idea to educate yourself on all aspects of the business. Fundamental analysis can give you a good understanding of the market sector, and will help when you are trying to assess the value of an initial public offering (IPO).  The numbers calculated when doing fundamental analysis are not a major influence in the current market view of the company, which is what matters when trading, but provide a setting and overall background to the task.


Leave a Reply