What it means
Every share represents a slice of ownership in a business, so analysing a stock begins with understanding the business. Fundamental analysts read the income statement, balance sheet and cash flow statement to judge growth, profitability and financial strength.
They also look at the industry, the competition and the quality of management. From that work they estimate what the shares are worth.
Common tools include ratios such as price-to-earnings (the share price divided by earnings per share) and discounted cash flow models, which add up the value today of a company's expected future cash. If the estimated value is above the market price, the shares may be undervalued.
Technical analysts take a different view and study past prices and trading volume to find patterns and trends. They use tools such as moving averages, support and resistance levels and momentum indicators.
Their belief is that prices reflect all available information and that patterns tend to repeat. Good analysis combines these views with an assessment of risk.
This includes company-specific risks such as debt and competition, and market-wide risks such as interest rates and recessions. Analysts often build several scenarios, optimistic, expected and pessimistic, instead of relying on a single forecast.
For non-finance professionals, the main lesson is that a good company is not always a good investment, because the price paid matters. It also pays to rely on quality information, which is the Gold in, Gold out principle: poor data produces poor conclusions.
Anyone making investment decisions should use reliable sources and take professional advice where appropriate. A useful habit is to write down, before buying, why you own a share and what would make you sell it.
That record guards against changing the story after the price moves. It also makes later reviews far more honest, because the original reasons can be compared with what actually happened.
In practice
Real-world examples.
Example
An analyst at an investment firm studies a food manufacturer. She finds revenue growing 6% a year, steady margins and low debt, and she compares its valuation with competitors. She recommends buying if the price falls below $72, her estimate of fair value.
Example
A private investor reads a retailer's annual report and sees that profit is rising while the cash flow statement shows cash falling. He investigates and finds the company is building up unsold stock. He decides to wait before investing, and checks the next quarterly report for a drop in inventory before reconsidering.
Example
A trader uses a 50-day moving average to time purchases of a bank share he already believes is good value. He buys when the price rises back above the average after a dip. He keeps a stop-loss in place in case the move fails.
Formula
Calculation
Price-to-earnings ratio = share price / earnings per share
Earnings per share = net profit / number of shares outstanding
Suppose a company earns a net profit of $20,000,000 and has 5,000,000 shares in issue. Earnings per share = 20,000,000 / 5,000,000 = $4. If the shares trade at $60, the price-to-earnings ratio is 60 / 4 = 15. If similar companies trade at an average of 18 times earnings, the shares look cheaper than their peers, as 18 x 4 = $72 would be the price at the peer average.Case study
Seen in the real world.
Halden Analytics is an illustrative, fictional research firm that studied a fictional engineering company called Corvane Industries. Corvane's shares had risen 35% in a year, and many investors assumed they were expensive.
The analysts found that earnings per share had risen from $2.00 to $3.50 and the price-to-earnings ratio had actually fallen from 22 to 17. They also noted that debt was falling and that an order book worth $250,000,000 provided visibility for the next two years.
On that basis they judged the shares fairly valued with moderate upside, and flagged the main risk as a downturn in the construction sector. The illustrative lesson is that a rising share price does not by itself mean a stock is expensive, so analysis must look at earnings and cash flow.
Watch out
Common mistakes.
- Judging a stock by its price alone, when a high price per share says nothing about whether the company is expensive.
- Relying on one ratio such as price-to-earnings, when it should be compared with growth, debt and cash flow.
- Confusing a good company with a good investment, when the price paid determines the return.
Questions
People also ask.
What is the difference between fundamental and technical analysis?
Fundamental analysis studies the business and its financials to estimate value, while technical analysis studies price and volume patterns to time trades.
How often should I review a stock?
Review it when results are published, when major news arrives and at least once or twice a year to check that the reasons for owning it still hold.
Is stock analysis a guarantee of returns?
No, it improves decisions but cannot remove uncertainty, because markets and businesses can change in unexpected ways.
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