Understand the Company First
If you want to succeed in the most basic form of stock analysis, you need a deep understanding of the company. Start with looking at the type of business the company conducts. What is its primary source of revenue? For example, if you are looking at Apple, be mindful that as of 2022, its primary source of revenue was iPhones . It made over $394 billion and 52% of it came from iPhones . Next, go into the financials. Look at the rate of growth of the revenues, profit margins, and cash flow statements. A typical healthy company, like Microsoft has a profit margin of more than 30%, meaning it spends $1 and earns more than $1.3 . Moreover, Microsoft has been cash flow positive for as long as one can remember. This means it can fund the business and the growth without needing to take any additional debt or equity.
Industry Position and Competitors
Comparing the company to the competition will also tell you a lot about it. Use tools like Porters’ Five Force to understand the dynamics. For example, for a retailer-like Walmart, you would need to look at companies like Amazon and Target . A report by Insider estimates that Walmart’s share of the total US retail market is about 25% .
Also, look at the industry as a whole. It is common sense that the renewable energy industry is in a much better position than the coal industry. According to McKinsey, the renewable industry is expected to grow at an annual rate of 8.4% until 2030 .
Management and Governance
Finally, the management is key. If the company is poorly managed, it will not perform well. Look at the track record of the people involved. Moreover, look at the governance. Companies with independent boards tend to do well. Additionally, look at the ownership structure. If the executive team owns less of a company, it is likely to destroy value. On the other hand, companies where the management and the founders own the company do better. For example, Larry Page and Sergey Brin, the founders of Google, owned about 52% of their company as of 2021.
Financial Metrics and Ratios
Price-to-Earnings is a crucial ratio to look at. If a company has a P/E lower than the average of the industry, it might be undervalued . The average P/E ratio for the S&P 500 as of 2022 is about 21, which means that anything lower than 21 can be a buy signal. Another important measure is the Return on Equity . This measures the amount of profit the company earns using the money of shareholders. Google, now owned by Alphabet had a return on equity of 28% in 2021 . This means the company could return up to 28% of the money the investors had invested in the company back.
Use Financial Ratios for Initial Screening
When you are just starting your search for stocks that might be fundamentally strong, financial ratios offer a convenient and effective way of preliminary screening. Ratios can help you differentiate between those companies that meet the set financial criteria and those that do not. Not all businesses are the same, so some might be considered more financially resilient than others, based on specific indicators.
Profitability Ratios
The stock’s performance can be determined using profitability ratios, such as Return on Equity and Return on Assets . The company with the reported ROE of over 15% is typically seen as financially sound . For instance, Apple Inc. had the ROE of 145.92% in the first quarter of 2022, far exceeding the average of about 20% for a technology sector . This demonstrates not only its profitability but efficient reinvestment of the earnings.
Liquidity Ratios
Liquidity ratios, like the Current Ratio and Quick Ratio, can inform the investor of the company’s financial capabilities to pay off its short-term debt without needing to raise extra capital . Overall, a current ratio of more than 1.0 implies that the entity can cover its short-term debt with its short-term assets. In 2022, Coca Cola’s current ratio was equal to 1.13, which is sufficient for automated trading strategies.
Leverage Ratios
An investor might be interested in leverage ratios, including the debt-to-equity (D/E) ratio, to assess the company’s approach to borrowing and appropriate debt use. As a general rule, a smaller D/E ratio indicates a company is not excessively borrowing funds to function. For a more conservative approach in terms of investment strategies, you should look for companies that have a D/E ratio under 1.0. Overall, Google, which is now Alphabet Inc., had a D/E ratio equal to 0.06 in 2022, demonstrating their small dependence on debt.
Efficiency Ratios
Efficiency ratios, such as Inventory Turnover and Asset Turnover, help the investor evaluate how well the entity can use its assets to generate sales. Their asset turnover ratio in 2021 was equal to 1.54, making it more efficient than the industry average of about 0.8 for retail companies.
Closely Study the Financial Reports of the Company
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Income statement review
It shows the revenue, sales, and profit for a particular period, which includes expenses spent on producing and selling the products or services. While analyzing the income statement, an investor must look for consistency in revenue growth and expenses level. For example: Tesla, Inc: The company had reported an annual increase in revenue, with sales expansion from $ 24,578 million in 2019 to 53,769 million in 2021.
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Balance sheet
This is the statement reflecting the company’s financial position at a specific point in time. Here, an investor must look for the key assets, including cash, receivable, payables, accumulated loans, and other payables. Also, one must take into consideration the equity of the company which helps in understanding the financial stability of the company. For example, Microsoft: As per its balance sheet of 2021, the company has $131,221 million in cash and short-term investments.
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Cash flow statement
CASH FLOW is the king. As per Warren Buffet, “In the world of business, the people who are most successful are those who are doing what they love.” It shows cash generated by the company from its core business operation and furthermore, how it is used in investing and financing activities. For example, Amazon: As per the cash flow statement of 2021, the company has a positive operating cash flow of $66,094 million that indicated that the company is very efficient in its core business operation in terms of financing, acquiring, and managing sales to convert them into actual cash.
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Notes and Management Discussion
Do not ignore them. They report different liabilities, risks, and controversial transactions. Here management gives a clearer picture of the company’s financial situation and discloses its plans. For example: Apple: MD&A-2021: The section gives insight into the strategies for innovation, market expansion, and for business growth.
Find the Company Competitors/Rivals and Study Them
Competitor analysis is likely one of the most critical steps in fundamental stock analysis as it serves as a baseline comparison and reveals the company’s status within the industry.
Step 1: Identify Key Competitors
Regularly, one can find the most important data in companies’ annual reports, industry analyses, and investor presentations. For example, if one is analyzing Netflix, key competitors may become Amazon Prime, Disney+ , and Hulu . Thus, one gains a sense of what the particular unit’s market share is relative to, how fast it is growing, and what types of products are gaining recognition.
Step 2: Compare Financial Health
One may wish to look at several financial metrics such as revenue, profit margins, and debt levels across competitors. For example, in the streaming sector, Netflix’s revenue grew by 24% compared to Disney+’s 81% in 2020. This comparison reveals the competitive dynamics and potential market share changes.
Step 3: Evaluate Market Position
Assess the market position and the strategy that each company employs. Who is a leader, and who is a follower? What value do they offer? Amazon Prime’s offering differs from Netflix’s as it is not just a streaming company but rather a “ shopping + entertainment ” bundle, which may target a different demographic.
Step 4: Study When Companies’ Products Get Outdated
Companies that develop new products or services or continually improve their offerings to be better than others’ remain at the top. For example, in the smartphone market, the iPhone products always have a significant edge as they are equipped with novel features and technologies that its major competitor, Samsung, lacks. The battle with Netflix, however, is problematic as the other streaming services try to offer similar options in terms of the variety of content.
Step 5: M&A Deals
Lastly, how does the market penetration or expansion compare? For example, Tesla’s construction of Gigafactories and the foray into China provide it with better production opportunities and market penetration than Ford or General Motors.
Check the Company Debt and Compare with Rivals
One of the most important aspects of fundamental analysis of a company is analyzing its debt levels in relation to the company’s competitors. Such assessment allows ensuring whether the company is financially stable and has appropriate risk exposure or lacks such characteristics. Therefore, when performing such analysis, it is important to start by understanding the debt structure of the company, calculating certain debt ratios, comparing these numbers against other companies, and analyzing how the company is managing its debt over time.
To understand the debt structure of a company, one needs to include both short- and long-term liabilities with interest payments attached . For instance, AT&T had long-term debt of approximately $147 billion at the end of fiscal year 2021 . It is critical to understand the terms of these debts, as well as the interest rates. In the case of my chosen company, Facebook (Meta), the company’s debt ratio was very low at 0.09 in 2021 . As for the debt ratios, one should calculate such ratios as the Debt-to-Equity ratio and Interest Coverage Ratio . For Meta, a low D/E ratio of 0.09 in 2021 implies strong financial health and almost no financial leverage . Another relevant method may include calculating its interest coverage ratio at 37.3075 times, which implies that the company can cover interest payments 38 times by its earnings .
To compare these debt ratios, it is critical to compare them to industry norms. For instance, a company in the retail industry will have more debt naturally due to the higher cost of inventory and operating the stores. Therefore, a D/E ratio at around 0.80 for Walmart could be considered appropriate for retail companies . To analyze the company’s debt management over time and compare debt levels to the competitors, one may analyze the example of Microsoft, which reduced its total debt from $75.3 billion in 2017 to $50 billion . A comparison with peers is also important as Facebook has almost no debt. Finally, a consideration of how the company’s debt affects its operational flexibility is also important with Google being an example of a technology giant with almost no debt.
Analyze the Company Future Prospects
Among many other important aspects of fundamental analysis, an evaluation of a company’s future prospects is one of the most important. This aspect covers recognition of the potential for growth, innovation, and market expansion rates because its value defines the direct relevance of the stock in a long-term perspective.
Evaluating Market Trends and Demand
The first step towards identifying prospects is to assess broader market trends and demand for a particular area of operation. For example, as electric vehicles are expected to reach astounding market share rates, a company like Tesla that produces innovative vehicles could be expected to grow in its value. According to a predict , the global electric vehicles market is expected to grow at a CAGR of around 22% from 2021 to 2030. Also, the more markets a company enters with its products, the more versatile its operations become. Every sector that Amazon develops and improves, such as cloud services or its grocery business, makes it less dependent on the success of its core market approach and expands revenue streams.
Expansion Plans
Another factor to analyze is the rate of expansion and the areas entered. When a company is planning to enter a new market, its expansion is going to be multiplied by the appeal of its innovative offers in this field. Also, when a company diversifies and introduces new lines of products, it mostly will grow in value along with the new prospects. For example, thanks to the Apple in-house chip development, the company is expected to grow in value even more in the future because the much more efficient operation of Apple’s future products depends on their developments. Apple has doubled its research and development budget in 2020 and 2021, with approximately 21.7 billion dollars spent on innovations in 2021. Its current focus area is augmented reality, which would require significant resources for its deployment in Apple’s products.
Regulatory and Economic Factors
Also, an important aspect is the economic and legal environment. For example, with the increased governmental support for green energies, a company like NextEra Energy in the renewable energy sector might grow faster. In contrast, Facebook was significantly affected by the increased privacy regulations in Europe and the US. Companies often require foreign markets to keep growing, so in many cases, successful foreign operation expands the company’s value Gaza-Luecke & Woosley . For example, Google’s successful partnerships with car manufacturers create yet another sector of revenues where Google enters with its android system.
