Chapter 3: Stock analysis
What is Fundamental analysis
Fundamental analysis is the process used to evaluate a stock by examining its underlying financial health and business performance.
It’s considered the most basic form of stock analysis, involving the review of key financial ratios and a deep dive into the company’s financial statements, including the balance sheet, income statement, and cash flow statement.
This approach helps investors determine the intrinsic value of a stock and assess its potential for future growth.
Key financial metrics
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The cash flow statement shows the actual cash coming in and going out of the company over a period. It’s divided into three sections: cash from operations (everyday business activities), cash from investing (buying/selling assets), and cash from financing (borrowing money or paying back loans). This statement helps you see how well the company manages its cash.
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The income statement shows a company’s revenues and expenses over a specific period, like a quarter or a year. It tells you how much money the company made (revenues) and how much it spent (expenses), ultimately showing whether the company made a profit (net income) or a loss.
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The balance sheet provides a snapshot of a company’s financial position at a specific point in time. It lists what the company owns (assets), what it owes (liabilities), and the difference between the two, which is the shareholders’ equity. It’s like a financial snapshot showing how stable the company is.
Revenue Growth
Revenue growth is the increase in a company’s sales over a specific period, usually measured from one quarter or year to the next. It shows how quickly a company’s business is expanding, indicating whether it’s attracting more customers or selling more products. In simple terms, it’s a way to see if the company is making more money than it did before.
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Revenue growth is important because it indicates whether a company is successfully expanding its business. Consistent growth in revenue suggests the company is gaining market share, attracting more customers, or increasing sales, which can lead to higher profits and a stronger position in the market. Investors often look at revenue growth to assess a company's potential for future success and profitability.
Revenue Growth Calculator
Hint: Revenue growth is calculated as:
((Current Revenue - Previous Revenue) / Previous Revenue) * 100%
An example
Nvidia
Nvidia
Earnings Growth
Earnings growth refers to the increase in a company’s net income over time, usually measured from one quarter or year to the next. It’s a key indicator of a company’s profitability and financial health. If a company consistently shows strong earnings growth, it suggests that the business is expanding and becoming more profitable, which is often a positive signal for investors. Essentially, earnings growth helps investors gauge how well a company is increasing its profits and, by extension, how likely it is to generate higher returns in the future.
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Earnings growth is crucial because it directly reflects a company's ability to generate increasing profits, which is a key driver of long-term stock price appreciation. When a company consistently shows strong earnings growth, it indicates that the business is expanding efficiently, managing costs well, and potentially capturing more market share. For investors, growing earnings suggest that the company may be able to pay higher dividends, reinvest in further growth, or improve its financial stability, making it a more attractive investment. In essence, strong earnings growth often leads to increased investor confidence, which can boost a company's stock price and overall market value.
An example
Arista networks
Earnings Growth Calculator
Hint: Earnings growth is calculated as:
((Current Earnings - Previous Earnings) / Previous Earnings) * 100%
Arista networks
Key ratios and metrics
Financial Ratios Calculator
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What It Is: The P/E ratio compares a company’s current stock price to its earnings per share (EPS).
Why It’s Important: The P/E ratio helps investors assess whether a stock is overvalued or undervalued compared to its earnings. A high P/E might indicate that investors expect strong future growth, while a low P/E could suggest the stock is undervalued or that the company is facing challenges.
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What It Is: The P/S ratio compares a company’s stock price to its revenue per share.
Why It’s Important: The P/S ratio helps investors understand how much they are paying for each dollar of a company’s sales. It’s particularly useful for evaluating companies that are not yet profitable, as it focuses on sales rather than earnings.
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What It Is: The P/B ratio compares a company’s market value to its book value (net assets).
Why It’s Important: The P/B ratio helps investors determine if a stock is trading at a fair value compared to its assets. A ratio below 1 could indicate the stock is undervalued, while a higher ratio might suggest overvaluation.
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What It Is: ROE measures a company’s profitability by showing how much profit it generates with the money shareholders have invested.
Why It’s Important: ROE indicates how efficiently a company is using its equity to generate profits. A higher ROE is generally seen as positive, showing effective management and strong financial performance.
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What It Is: The debt-to-equity ratio compares a company’s total debt to its shareholders’ equity.
Why It’s Important: This ratio shows the proportion of debt a company is using to finance its assets relative to equity. A higher ratio indicates more leverage, which can be risky, while a lower ratio suggests a more conservative financial structure.
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What It Is: ROI measures the efficiency of an investment by calculating the return relative to the investment’s cost.
Why It’s Important: ROI provides a simple way to evaluate the profitability of an investment. A higher ROI indicates a more profitable investment, making it a crucial metric for comparing different investment opportunities.
Common mistakes
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Financial ratios, such as P/E, P/S, P/B, ROE, Debt-to-Equity, and ROI, are powerful tools for evaluating a company’s financial health and performance. However, relying solely on these ratios without understanding the context can lead to significant mistakes in investment decisions.
Ratios are merely numbers that reflect certain aspects of a company's financials, but they don’t tell the full story. For instance, a high P/E ratio might suggest that a stock is overvalued, but if the company is in a rapidly growing industry with strong future prospects, that high P/E could be justified. Similarly, a low P/B ratio might indicate a bargain, but if the company is struggling with declining revenues or outdated assets, the low P/B might reflect deeper problems.
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While it’s tempting to set strict rules for financial ratios (e.g., "never invest in a stock with a P/E above 20"), doing so can cause you to miss out on valuable investment opportunities. Financial ratios should be used as guides rather than strict rules, as there are many factors that can influence these numbers.
For example, a company with a high Debt-to-Equity ratio might initially seem risky, but if it’s using that debt to fund high-return investments, the risk could be worth it. Similarly, a company with a low ROE might still be a great investment if it has other strengths, such as a strong brand, a loyal customer base, or significant growth potential.