How to Use Fundamental Analysis in Stock Trading

Many people check the food labels of the items they buy in the grocery store. Labels can help give them an indication of what they buy to eat is good for them.

Similarly, publicly listed companies have the equivalent of a label that investors can use to check the soundness of companies. It comes in the form of fundamental analysis.

The information provided from fundamental analysis is considerably more complex than food labels. But it is available to help investors value companies correctly.

Fundamental analysis attempts to derive a company’s “intrinsic” value. Investors examine the financial position of companies. They also evaluate current economic conditions for these businesses. 

Some investors use a rigorous approach to fundamental analysis. They examine the cost of capital of a firm and discount the cash flows associated with those costs.

The results of the calculation produce what many investors believe is a company’s intrinsic value.

The biggest drawback to this approach, known as the discounted cash flows, is the investor’s assumptions. The model is sensitive to these assumptions. Likely, two investors may not arrive at the same conclusions when using these methods.

Another approach is to use comparables of other companies in an industry. Another name for this is the multiples approach. This approach is similar to valuing houses in a neighborhood. 

It works by finding several companies in the same industry and applying the average of the industry multiples multiplied by a value driver of the target company.

Investors can use measures like the price-to-earnings ratio or the price-to-book ratio for the multiples.

Refining the approach

Some investors refine this methodology even further by attempting to find one company closely related to the target company. Then, they multiply a multiple such as price-to-earnings to that comparable company’s earnings or other measures that determine value.

The comparables method relies on the law of one price, which states that two companies with the same risk profile and earnings will have the same price.

If the prices deviate at any point arbitrageurs will step in, causing the prices to match.

A challenge with this approach is finding companies that are a close match to the target company. Large corporations have multiple business units. They also own subsidiaries. 

For example, Microsoft sells operating systems, but it also creates productivity software. It is involved with cloud computing services, and currently, own career site LinkedIn. Microsoft is not alone in the wide number of different companies and business functions it manages.

Some investors use a Goldilock’s approach to determine if stocks are overvalued, undervalued or properly valued. They set a threshold that determines the status of the valuation.

For instance, some investors consider any stock with a price-to-earnings ratio over 20 to be overvalued. Investors are free to use a variety of methods to determine the proper thresholds, including guessing.

Keeping valuation simple

Perhaps the easiest valuation approach is to compare the multiples (such as the price-to-earnings ratio) against a company’s own historical multiple. For instance, if the average of the past 10 years price-to-earnings ratio is 15, a current ratio of 12 may lead investors to believe the stock is cheap.

You may choose to implement several of the described approaches to determine the value of a stock. You could calculate each of them and take the average of the results. 

Investors should also consider the industry of any company they are analyzing. Automobile companies, such as General Motors, were the darlings of Wall Street for several decades.

Today, many investors shy away from companies in this industry for a variety of reasons.

There is quite a bit more to fundamental analysis than the few concepts presented here. New concepts are added and old ones are redefined.

Over time, investors find the measures that work for their investment goals. They take stock of the effectiveness of the measures and make adjustments as they see fit.

Recommended Articles

8 Unconventional and Fun Ways to Make Extra Money

The number one formula for making money is that there is no formula. In fact, if you are willing to move away from the traditional path to earn money you

Science Says the Perfect Female Body Should Look Like This

Everyone has their own opinion of what the female body should look like. Society and the media often exhibit women that are thin as the ideal womanly figure. This causes

Americans Are More Afraid of Doctor Bills Than They Are of Being Sick

The skyrocketing cost of healthcare has become prohibitive for many Americans. More people seem to be skipping physician visits, and U.S. healthcare costs rose to $10,000 a year per person in

Your Meat Is Treated with Carbon Monoxide to Make It Look Fresh

When you are looking for a nice steak, pork chops or chicken at your grocery store one of the main things you look for is the color of the meat.

Anxiety? 10 Foods You Should Be Eating (and What To Avoid!)

Occasional anxiety is a part of life. You may feel anxious when faced with a problem at work, before making a big change, or deciding on an important decision. But anxiety disorders

5 Gig Economy Tips That Will Help You Succeed

The gig economy has been expanding at a scorching pace, with some surveys indicating that nearly one in three American workers now participate in it, whether part-time or full-time. A

7 Genius Food Tricks You Can Do at Home

Everyone likes to have fun and cook, right? There are many cool hacks and tricks out there nowadays that make kitchen time more fun. Making time in the kitchen more

3 Powerful Ways to Invest in Mexico

Mexico has a rich and deep history that can be traced back thousands of years. The country has tourism hubs in the Caribbean and the Pacific, beautiful colonial towns and

Unclaimed Money: How to Find and Recover Your Lost 401(k) Money

A crisis is looming on the horizon — and it's not the same old story about workers who haven't saved enough. This calamity is affecting would-be retirees who can’t find

7 Profound Personal Finance Practices to Follow

Nearly 57% of American adults have savings of less than $1,000, while 39% have zero savings. Following a few quintessential personal finance practices, however, can help you achieve a healthier

FIRE Your Old Financial Life and Retire Early. Here’s How…

A Chicago flight attendant has hit the news for turning her financial life around. At 39, Bianca DiValerio was nearly broke after a divorce and the sale of several failing

Interview: Rates Will Stay Low, Uber ‘to the Moon’

Don't expect the Federal Reserve to even tap on the brakes anytime soon, says Bob Iaccino, editor of the Stock Think Tank. On Thursday, Fed Chairman Jerome threw cold water