Credit: Shutterstock photoIn today's online, computer-driven investing world, fundamental analysis often plays second fiddle to technical analysis when it comes to choosing stock market investments.
While technical analysis has its place in stock picking, it's really only one piece of the puzzle. The most successful investors use a combination of both types of analysis to make investing decisions.
What Is Fundamental Analysis?
Fundamental analysis can be defined as studying anystock market dataother than a stock's price movement. It can be applied to the entire market or broken down for individual companies. For the purposes of this article, I will focus on fundamental analysis as it is applied to corporations and not to the overall stock market.
Fundamental analysts sift through documents like balance sheets, financial statements, earnings reports, breaking news, management backgrounds, and financial data related to the firm's competitors. With this data in hand, fundamental analysts use certain metrics to ascertain the financial health of a company.
There are dozens of parameters that can be used to shed light on a publicly-traded firm. So many, in fact, investors sometimes avoid fundamental analysis due to the sheer data overload. With that said, for the average investor there are only a few fundamental metrics that are crucial to understand.
This article will delve into what I consider the three most critical fundamental metrics.
1. Return On Equity
I have found this to be the most important of all the fundamental metrics. Overall known as a profitability ratio, Return on Equity, or ROE, focuses on an actual driver of stock prices: profits.
In essence, this ratio separates out the profits earned with shareholder equity. I know that may seem complicated, but the calculation is actually rather straightforward. ROE is determined by dividing net income by average common shareholder's equity. The average is used since a company can quickly change the number of outstanding shares by buying back shares or issuing new shares.
All else equal, the higher the ROE, the better off the company is. Firms with high ROE have a better ability to generate cash than companies with a lower ROE. In the real world, there are exceptions to this rule.
Companies with lower asset requirements can have high ROEs yet struggle to maintain the ROE due to competition. At the same time, some firms, like those in the transportation and energy sectors, may have naturally low ROE due to the reliance on capital spending to launch the company.
It's critical to understand the sector to adequately use the ROE metric as a stock picking tool. The ROE for a given company can be compared to that of its competitors or an industry average to get a better idea of where that company stands.
2. Price/Earnings Ratio
My second favorite fundamental metric is used to determine if a stock is cheap or expensive relative to others in the same sector. The correct use of this metric is what can make the difference between success and failure in the stock market.
The Price/Earnings ratio, typically called P/E in financial media, is very easy to understand. It's simply the current stock price divided by its earnings per share ( EPS ). However, it is neglected by all but the very best investors.
There are several different ways to calculate P/E. While most investors use the traditional trailing P/E, which incorporates with the last four quarters of EPS, I like the leading or estimated P/E calculation best. This calculation uses the forecasted EPS for the next four quarters.
While the projected EPS may not be entirely accurate, analysts often have an excellent idea about what to expect for the next year regarding EPS. The past does not equal the future in the stock market, and by using the estimated future EPS to calculate leading P/E, investors can gain a better idea of what to expect in the future.
3. Free Cash Flow
Next on my list is the free cash flow metric. Free cash flow is defined as operating cash flow minus capital expenditures.
Cash is the lifeblood of every company and is what a company uses to improve shareholder value. Firms with high free cash flow can fund innovation, pay dividends, and survive lean times better than less-liquid companies.
It's important to note that high earnings do not equal healthy free cash flow. While this may seem contradictory, it's due to GAAP accounting standards not using cash balances to calculate earnings.
Investors should also keep in mind that negative free cash flow may reflect recent investment rather than a weak period for the enterprise.
Risks To Consider: Fundamental analysis can be deceiving at times. Always try to find the reasons behind the numbers rather than simply making decisions based on the metrics.
Action To Take: Use technical analysis to choose stocks then apply these three metrics to see if the technical price move is supported before investing.
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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
