3 Key Pillars of Fundamental Analysis

If you want to invest in the stock market, you need to have a solid strategy that can help you identify the best stocks to buy. One of the most popular and effective methods of stock analysis is fundamental analysis. Fundamental analysis is the process of evaluating a company’s financial performance, health, and growth potential by looking at its financial statements and other relevant data. By doing so, you can determine the intrinsic value of a stock, which is the true worth of a company based on its fundamentals. This can help you find undervalued or overvalued stocks and make informed investment decisions.

But how do you perform fundamental analysis? What are the key financial statements and ratios that you need to look at? And how do you use them to compare and rank different stocks? In this blog post, we will answer these questions and show you how to master the art of fundamental analysis and pick winning stocks. We will also share some tips and tricks to make your analysis easier and more effective. Let’s get started!

The 3 Pillars of Fundamental Analysis: Balance Sheet, Income Statement, and Cash Flow Statement

The first step of fundamental analysis is to look at the three main financial statements of a company: the balance sheet, the income statement, and the cash flow statement. These statements provide a comprehensive overview of a company’s financial position, performance, and cash flows. They are also the source of many important financial ratios and indicators that can help you assess a company’s profitability, liquidity, solvency, efficiency, and growth.

Balance Sheet

The balance sheet is a snapshot of a company’s assets, liabilities, and shareholders’ equity at a specific point in time. It shows what a company owns, what it owes, and what is left for the owners after paying off the debts. The balance sheet follows the basic accounting equation:

Assets = Liabilities + Shareholders’ Equity

Assets are the resources that a company uses to generate income, such as cash, inventory, property, plant, and equipment. Liabilities are the obligations that a company has to pay, such as accounts payable, loans, and bonds. Shareholders’ equity is the difference between assets and liabilities, and represents the owners’ claim on the company’s assets.

The balance sheet can help you evaluate a company’s financial strength and stability by looking at its liquidity, solvency, and capital structure. Some of the key ratios that you can calculate from the balance sheet are:

• Current ratio: Current assets / Current liabilities. This ratio measures a company’s ability to pay its short-term obligations with its current assets. A higher current ratio indicates better liquidity and lower default risk.

• Debt-to-equity ratio: Total debt / Total equity. This ratio measures a company’s leverage, or how much debt it uses to finance its operations. A higher debt-to-equity ratio indicates higher financial risk and lower financial flexibility.

• Return on equity: Net income / Average equity. This ratio measures a company’s profitability, or how much income it generates for each dollar of equity. A higher return on equity indicates higher efficiency and profitability.

Income Statement

The income statement is a summary of a company’s revenues, expenses, and profits over a period of time, usually a quarter or a year. It shows how a company earns money, how much it spends, and how much it keeps as profit. The income statement follows the basic equation:

Revenue - Expenses = Profit

Revenue is the amount of money that a company receives from selling its goods or services. Expenses are the costs that a company incurs to generate revenue, such as cost of goods sold, operating expenses, interest, and taxes. Profit is the difference between revenue and expenses, and represents the amount of money that a company earns or loses.

The income statement can help you evaluate a company’s financial performance and growth potential by looking at its profitability, efficiency, and margins. Some of the key ratios that you can calculate from the income statement are:

• Earnings per share: Net income / Average shares outstanding. This ratio measures a company’s earnings, or how much profit it makes for each share of stock. A higher earnings per share indicates higher profitability and shareholder value.

• Price-to-earnings ratio: Stock price / Earnings per share. This ratio measures a company’s valuation, or how much investors are willing to pay for each dollar of earnings. A higher price-to-earnings ratio indicates higher expectations and growth potential.

• Gross margin: Gross profit / Revenue. This ratio measures a company’s efficiency, or how much of its revenue it keeps as gross profit after paying for the cost of goods sold. A higher gross margin indicates lower production costs and higher profitability.

Cash Flow Statement

The cash flow statement is a record of a company’s cash inflows and outflows over a period of time. It shows how a company generates and uses cash from its operating, investing, and financing activities. The cash flow statement follows the basic equation:

Cash flow from operations + Cash flow from investing + Cash flow from financing = Change in cash

Cash flow from operations is the amount of cash that a company generates from its core business activities, such as selling goods or services, paying suppliers, and collecting payments. Cash flow from investing is the amount of cash that a company spends or receives from its investing activities, such as buying or selling assets, making loans, or acquiring other companies. Cash flow from financing is the amount of cash that a company raises or pays from its financing activities, such as issuing or repaying debt, paying dividends, or buying back shares.

The cash flow statement can help you evaluate a company’s financial health and growth potential by looking at its cash generation, cash management, and cash availability. Some of the key ratios that you can calculate from the cash flow statement are:

• Operating cash flow ratio: Operating cash flow / Current liabilities. This ratio measures a company’s ability to pay its current liabilities with its operating cash flow. A higher operating cash flow ratio indicates better liquidity and solvency.

• Free cash flow: Operating cash flow - Capital expenditures. This ratio measures a company’s excess cash flow, or how much cash it has left after paying for its operating and investing activities. A higher free cash flow indicates more financial flexibility and growth opportunities.

• Cash flow to earnings ratio: Operating cash flow / Net income. This ratio measures a company’s quality of earnings, or how much of its earnings are backed by cash. A higher cash flow to earnings ratio indicates more reliable and sustainable earnings.

How to Use Fundamental Analysis to Pick Winning Stocks

Now that you know the basics of fundamental analysis and the key financial statements and ratios, how do you use them to pick winning stocks? Here are some steps that you can follow to conduct your own fundamental analysis and find undervalued or overvalued stocks.

Step 1: Screen for Potential Stocks

The first step is to narrow down your search for potential stocks by using a stock screener. A stock screener is a tool that allows you to filter stocks based on various criteria, such as market cap, sector, industry, dividend yield, earnings growth, and so on. You can use a stock screener to find stocks that match your investment objectives, preferences, and risk tolerance.

For example, if you are looking for large-cap stocks in the technology sector that have a high dividend yield and a low price-to-earnings ratio, you can use a stock screener to find stocks that meet these criteria. You can also use a stock screener to exclude stocks that do not meet your criteria, such as stocks that have negative earnings, high debt, or low liquidity.

There are many free and paid stock screeners available online, such as Yahoo Finance, Finviz, Zacks, and Morningstar. You can also use Ahrefs’ Keywords Explorer to find popular and trending keywords related to your topic and use them as filters for your stock screener.

Step 2: Analyze the Financial Statements and Ratios

The next step is to analyze the financial statements and ratios of the stocks that you have screened. You can find the financial statements and ratios of any public company on its website, on its annual report, or on financial websites such as Yahoo Finance, MarketBeat, or Seeking Alpha. You can also use Ahrefs’ Site Explorer to find the most authoritative and relevant websites that cover your topic and provide financial analysis and insights.

You should analyze the financial statements and ratios of the stocks that you have screened from both an absolute and a relative perspective. An absolute perspective means looking at the historical trends and patterns of the financial statements and ratios over time. A relative perspective means comparing the financial statements and ratios of the stocks with their peers, competitors, industry averages, and benchmarks.

For example, if you are analyzing the balance sheet of a stock, you should look at how its assets, liabilities, and equity have changed over time, and how they compare with other stocks in the same industry or sector. You should also look at how its liquidity, solvency, and capital structure have changed over time, and how they compare with other stocks in the same industry or sector.

You should analyze the financial statements and ratios of the stocks that you have screened from both a qualitative and a quantitative perspective. A qualitative perspective means looking at the underlying factors and drivers that affect the financial statements and ratios. A quantitative perspective means looking at the numerical values and calculations of the financial statements and ratios.

For example, if you are analyzing the income statement of a stock, you should look at what factors affect its revenue, expenses, and profit, such as market demand, pricing strategy, cost structure, and competitive advantage. You should also look at the net margin, operating margin, and EBITDA margin of the stock, which measure how much of its revenue it keeps as net profit, operating profit, and earnings before interest, taxes, depreciation, and amortization, respectively. A higher margin indicates higher profitability and efficiency.

Step 3: Evaluate the Intrinsic Value and Margin of Safety

The final step of fundamental analysis is to evaluate the intrinsic value and margin of safety of the stocks that you have screened. The intrinsic value is the true worth of a stock based on its fundamentals, and the margin of safety is the difference between the intrinsic value and the market price. The goal of fundamental analysis is to find stocks that are trading below their intrinsic value, or undervalued stocks, and avoid stocks that are trading above their intrinsic value, or overvalued stocks.

There are many methods and models that you can use to estimate the intrinsic value of a stock, such as the discounted cash flow model, the dividend discount model, the earnings power value model, and the residual income model. These models use different assumptions and inputs, such as future cash flows, growth rates, discount rates, and terminal values, to calculate the present value of a stock. You can use online calculators, spreadsheets, or software to perform these calculations, or you can use Ahrefs’ Content Explorer to find the most popular and authoritative articles that explain how to use these models and provide examples and templates.

However, you should keep in mind that the intrinsic value of a stock is not a precise number, but a range or an estimate that depends on the accuracy and reliability of the data and the assumptions that you use. Therefore, you should always apply a margin of safety to your intrinsic value estimate, which is a percentage or a buffer that you subtract from the intrinsic value to account for the uncertainty and the margin of error. The margin of safety can vary depending on your risk tolerance, confidence level, and market conditions, but a common rule of thumb is to use a margin of safety of at least 20% to 50%.

For example, if you estimate that the intrinsic value of a stock is $100, and you apply a margin of safety of 30%, then your target price for the stock is $70. This means that you would only buy the stock if its market price is below $70, and you would sell the stock if its market price is above $100. This way, you can reduce your downside risk and increase your upside potential.

Conclusion

Fundamental analysis is a powerful and proven method of stock analysis that can help you identify the best stocks to buy and avoid the worst stocks to sell. By looking at the financial statements and ratios of a company, you can evaluate its financial performance, health, and growth potential, and estimate its intrinsic value and margin of safety. By doing so, you can find undervalued or overvalued stocks and make informed investment decisions.

However, fundamental analysis is not a simple or easy process. It requires a lot of research, data, and calculations, and it involves a lot of assumptions, estimates, and uncertainties. Therefore, you should always do your own due diligence, use multiple sources and methods, and apply critical thinking and common sense when performing fundamental analysis. You should also complement your fundamental analysis with other types of analysis, such as technical analysis, sentiment analysis, and macroeconomic analysis, to get a more holistic and comprehensive view of the stock market.

We hope that this blog post has given you a basic understanding of how to perform fundamental analysis and pick winning stocks. If you want to learn more about fundamental analysis and other topics related to stock investing, you can check out our other blog posts, subscribe to our newsletter, or follow us on social media. Thank you for reading and happy investing!