Fundamental Stock Analysis for Novices
Fundamental stock analysis can seem scary to most newcomers to the market – and with some reason. Looking at some of the 30-page reports from broking houses, about just one company, can seem stupefying to the best of us.
However, one of the reasons it appears terrifying is that analysts can make it as complex as they like: there’s virtually no end to the level of calculations you can perform.
Importantly, when it comes to numbers, there’s a simple four-step process to fundamental stock analysis of companies. First, is the company likely to still be around in a year? Second, is there cash coming in? Third, is the company making money from this cash? And, last, are you likely to get any of that cash?
1. Balance Sheet
A balance sheet is a snapshot of a business’ financial condition at a specific moment in time. From this, analysts try to identify whether the company is financially healthy, especially in relation to debt.
A balance sheet comprises assets, liabilities, and owners’ or stockholders’ equity. Assets and liabilities are divided into short and long-term obligations including cash accounts such as checking, money market, or government securities.
At any given time, assets must equal liabilities plus owners’ equity. An asset is anything the business owns that has monetary value. Liabilities are the claims of creditors against the assets of the business.
2. Cash Flow Statement:
This is a financial document detailing the exchange of cash between a business and the outside world. The flow is categorised as:
- flow “in” from Operations (cash the company made by selling goods and services)
- flow “in” from Financing (cash the company raised by selling stocks and bonds)
- flow “out” to Investing (cash the company spent investing in its future growth)
Each of these flows can actually flow both ways. It is a measure of a company’s financial activity. Investors like to see that the company can cover its spending with cash from operations, without having to turn to financing.
The cash flow statement also has to reconcile the net effect of these flows with the difference in its cash holdings at the beginning and end dates of the reporting period.
3. Earnings per Share (EPS)
Total earnings divided by the number of outstanding common shares. Great companies have earnings that are growing quarter by quarter, year on year.
However if the number of shares have increased markedly or there has been a merger, the earnings per share can be diluted. Therefore, earnings per share are more important to the investor than total earnings.
Dividends are distributions of money, stock, or other property a corporation pays you because you own stock in that corporation. Most are paid in cash, but you can also be paid in shares.
Basically dividends constitute the element of profit the company does not reinvest back into itself. Shareholders will pay income tax with respect to their dividend income.
These four measures aren’t the full story, however. A company might look great, but it might be very expensive. The next step in stock analysis is to understand how much you are paying for the company.