A Short Course on Fundamental Analysis: Insights On Indicators
Fundamentals can provide useful insights into the corporate and economic indicators that will help you find companies with the potential to outperform.
- Use economic indicators for a general sense of how certain sectors may perform
- Learn which monthly reports to watch for that can affect your portfolio
- Calculate key ratios that can make good indicators for fundamental analysis
Key indicators are an important part of fundamental analysis, which is when investors consider core factors of an asset that can drive its price and value. This method helps investors determine the intrinsic value of an asset, so they can decide whether to buy it.
Investors using fundamental analysis look at the broader economic environment and the financial aspects of a company instead of daily technical patterns. Value investors often use fundamental analysis to help them identify a stock that is undervalued, and perhaps poised for gains.
Of course, no indicator can predict a company’s fundamental health with 100% certainty, but there are a number of indicators that can give investors valuable guidance on what to expect in trading trends. When looking at a company’s financials, several ratios can provide clues as to how strong the company is, both compared to its peers and compared to its past performance.
Some of the more commonly used ratios when measuring a company’s performance include the price-to-earnings ratio, debt-to-equity ratio and price-to-book ratio.
The price-to-earnings ratio, or P/E, is essentially a measure of how expensive a stock is compared to its earnings, either past or future, depending on how it is calculated.
A higher P/E ratio compared to other companies in its sector could indicate that the stock is fairly expensive, whereas a lower P/E ratio could signal a bargain. Essentially, it helps investors determine if the stock is overvalued or undervalued.
To calculate the P/E. divide the current price per share that the stock is trading for, which is a price simply set by supply and demand, by the earnings per share (EPS). For the EPS, you can use the average of the last four quarters, or the estimates for the future four quarters. So, a company can have more than one P/E ratio. When you use this key metric to compare companies, make sure you are using a P/E that is calculated the same way for each company.
The debt-to-equity ratio, or D/E, measures a company’s debt load as it compares to its net assets. It’s useful in fundamental analysis because it helps put a company’s debt in perspective.
The D/E can be used to asses a company’s risk, as companies that are more leveraged with debt are often less likely to perform as well as their peers with less debt. A lower D/E indicates that company is using less debt, so it would be less of a risk than a company with a higher D/E.
To calculate the D/E, divide the total liabilities by the total shareholder equity. Both the total liabilities and the total shareholder equity should be found on the company’s balance sheet. Like the price-to-earnings ratio, there is more than one way to calculate this, for example by using just the liabilities under “debt” and dividing that by the total equity. Again, ensure any company-to-company comparisons with D/E ratios are calculated the same way.
The price-to-book ratio, or P/B, is another ratio commonly used by value investors in fundamental analysis to help determine if a stock is undervalued. It’s basically a comparison of a company’s worth, or what its value would be if its assets were sold and its debt was paid, against its current price. So, this can be a good indicator when looking for bargains.
If the P/B is close to 1, then the company is trading for nearly what it is currently worth. Value investors look for lower P/B ratios. For example, a company with a P/B of 0.5 would be selling for less than what it’s book value, indicating a bargain.
To calculate the price-to-book ratio, first determine the book value per share by subtracting total liabilities from total assets, then dividing that by the total shares outstanding. Finally, divide the book value per share to the price per share.
Economic indicators are used in fundamental analysis to provide a sense of where the economy may be heading, and where a particular stock may be heading as a result. For example, economic indicators related to using like new home sales or home sale prices can reveal critical information about the housing market, which can affect homebuilding or home improvement stocks.
While economic reports can trigger short-term stock movements, especially if their conclusions are not what economists expected, they are valuable to fundamental analysis for the longer-term picture as well. One of the more closely watched economic indicators is the quarterly U.S. Gross Domestic Product (GDP), which gives a picture of the production of goods and services and a general sense of how the economy is faring.
Many investors are also tuned in to moves from the Federal Reserve, particularly whether it raises or lowers interest rates. Interest rates can have several economic consequences, from making mortgages more or less affordable for consumers to affecting profitability among banks.
On a monthly basis, investors can look at a number of economic reports, many of which are released by the U.S. Census Bureau or the U.S. Department of Labor. They include:
- Non-farm payrolls employment report reveals data on construction, goods and manufacturing.
- Unemployment rate is an indicator about the health of the labor force.
- The Produce Price Index (PPI) reveals the price producers report they receive for their goods, which can indicate trends in prices consumers will pay.
- The Consumer Price Index (CPI) measures changes in what consumers pay for particular goods.
- Retail Trade Report provides data on various niches within the retail sector.
The Bottom Line
For a more thorough fundamental analysis, consider several key indicators to help you determine whether a company is fundamentally strong or weak, and whether it is one you want to consider buying. By using more than one indicator in your analysis, you can get a more comprehensive view of the company.
All in all, the essence of fundamental analysis resides in examining a company’s financial reports and analyzing important ratios while factoring in economic reports to gain a better understanding of whether a stock can be a good addition to your portfolio.