Fundamental Analysis of Stocks: Key Concepts, Metrics, and Techniques

If you know people who have a knack for navigating the stock market, you may think they're magic, or at least lucky. In fact, they probably just have a solid understanding of fundamental analysis. Fundamental analysis involves assessing a company’s financial performance, along with its market position and other economic factors, to understand its real value.¹

Fundamental analysis gives you, as a long-term investor, insights into where to put your money. It helps you see beyond a company’s stock price, so it helps you make better investment decisions. You learn to assess a company’s long-term growth potential to make more informed choices. As an executive, fundamental analysis also helps you see your company's competitive edge. Keep reading to learn how to perform this analysis.

Core Principles of Fundamental Analysis

Understanding fundamental analysis lets you determine if a company’s stock is currently being over-valued or under-valued compared to the rest of the market. It involves looking at a company’s financial data along with economic conditions as a whole, a company’s market position, and sector-specific factors influencing the company’s finances. As explained by the stock market and financial data information source Financial Modeling Prep API, fundamental analysis involves five core principles:²

1. Earnings and revenue growth: Study the revenue and earnings growth over time to evaluate the company's ability to generate profit
2. Valuation: Assesses whether a stock is under- or overvalued. Common valuation methods include comparing price-to-earnings (P/E) ratios and price-to-book (P/B) ratios with industry peers.
3. Management and corporate governance: Determines how well a company's management team can lead the business effectively
4. Economic and industry factors: Consider macroeconomic factors—inflation rates, gross domestic product growth, unemployment rates—which may influence the company’s performance
5. Debt levels: Carefully examine a company's leverage, focusing on its ability to manage and service debt. High debt levels can be risky, especially when economic conditions are challenging.

Fundamental analysis starts with a company’s intrinsic value: what a stock is worth regardless of its current market price.³ It differs from technical analysis, which is an assessment of a stock’s historical price and volume data.⁴ Technical analysis is more appropriate for making short-term decisions and detecting patterns in the market, while fundamental analysis gives you a better view of a company's long-term position.⁵

Key Financial Statements Used in Fundamental Analysis

Start your fundamental analysis by looking at a company’s balance sheet, income statement, and cash flow statement.⁶ The balance sheet, also known as the profit and loss statement, will give you an overview of a company’s current resources and outstanding financial obligations. The income statement will tell you how much revenue a company is earning from its operations in relation to its expenses. The cash flow statement lets you assess how much cash a company has on hand, where it comes from, and how the company is spending it.

Together, these documents give you an idea of the company’s current position and its potential for growth. For example, if a company looks profitable, but you can see that it is spending money faster than it’s earning it, you might want to steer clear of that investment.

Essential Metrics and Ratios in Fundamental Analysis

A company’s financial statements will also give you the data you need to calculate various financial ratios, including the following:

• Price-to-Earnings (P/E): Indicates the ratio of the company’s share price to its earnings per share. Calculate it by dividing the market price per share by the company’s earnings per share
• Price-to-Book (P/B): Indicates the ratio of a company’s market value to its book value. Calculate it by dividing the stock price by the company’s book value
• Debt-to-Equity (D/E): Indicates the ratio of a company’s debt in relation to its equity. Calculate it by dividing the total liabilities by the total shareholders’ equity
• Return on Equity (ROE): Measures a company’s profitability in relation to its equity. Calculate it by dividing the net income by the shareholders’ equity
• Return on Assets: Measures profitability in relation to a company’s assets. Calculate it by dividing net income by the total assets
• Earnings per share: Refers to a company’s profitability per share of its stock
• Dividend yield: Refers to how much the company pays to its shareholders

Valuation Models for Stock Analysis

There are multiple models you can use to value stocks, including these common methods:⁷

• Discounted Cash Flow: Use this model when a company doesn’t pay dividends regularly or at all. Look at forecast cash flows and discount them to predict how much money your investment will generate. This method relies on cash flow analysis, and you need an accurate general idea of a company’s future cash flow
• Dividend Discount Model: Assess a company’s dividend payments over a set time range to see if they are stable
• Comparable Company Analysis (Comps): This valuation model is a quick and easy way to assess a company’s market performance by comparing its stock price to others in the industry

Qualitative Factors in Fundamental Analysis

The primary types of fundamental analysis are quantitative and qualitative. Quantitative methods involve reviewing financial statements, calculating ratios, and using data to estimate a company’s intrinsic value. Qualitative analysis considers non-quantifiable factors that contribute to a company’s success.

Start by assessing management quality and corporate governance. The right leadership can make or break a company. For example, in the early 2000s, Enron was a stock market darling set to make money for multiple investors. However, the company’s leaders weren’t really managing the company. Instead, they were committing accounting fraud, artificially inflating the company’s books to bump up the stock price.⁸ If a company you’re interested in gets new leaders, do some background research to see how they have managed previous companies.

Next, consider industry trends and the company’s market position. A company can perform well in a declining industry by adapting and shifting its business model. For example, AT&T was once a giant in the telephone business. As customers moved away from landlines and older technology, AT&T has maintained its place in the market by investing in new technology and infrastructure.⁹ Consider how a company adapts to industry changes along with its competitive position in the landscape.

Steps to Conduct a Comprehensive Fundamental Analysis

When you’re ready to conduct a fundamental analysis, start by gathering and analyzing relevant data to get to know the company. Scour the company’s website for an annual report with financial statements. Any company that is publicly traded is required to file financial statements with the Securities and Exchanges Commission.¹⁰ If you can’t find their financials on the company site, contact the SEC.

When you find the company's financial information, calculate various financial ratios discussed earlier. Read the CEO's introduction to the annual report to assess goals and other factors that impacted the company's financial decisions.

Supplement financial statements with financial magazines and websites and industry publications. These sources will help you understand a company's position in the market relative to its competitors. Use them to see how the company you're researching differentiates itself.

Next, look at the company's debt levels and compare them to others in the industry. Evaluate broader economic factors impacting the industry as a whole. Is there a labor shortage? Is inflation causing people to stop buying certain products?

Finally, assess a company’s economic moat, or its ability to maintain a competitive advantage.¹¹ Factors contributing to an economic moat include the following:

• Low production costs
• Patents
• High switching costs
• Strong brand loyalty

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