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.

4. Dividends

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.

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Stock analysis can be formed in a number of ways, but the end goal is determining a stock’s value.

As a brief summary, these are the stock value techniques most often used in the Australian stock market:

Discounted cash flow - is the most complex of valuation techniques but also among the most commonly used in stock analysis.

Under this technique, an investor or analyst will use a range of variables to try to accurately predict profit results for future years. These future earnings are then discounted back to their present value (value in today’s dollars) to give an estimate of what the company is currently worth (as a whole, or per share).

This technique is best used for companies in which earnings are expected to fluctuate or grow, start-ups, and companies with limited life spans.

Earnings before interest, tax, depreciation and amortisation (EBITDA) – should be used when most comparable companies are based overseas. For example, analysts rating telecommunications companies will often use this technique.

This technique strips out much of the financing and taxation effects from a company’s performance and leaves you with an indication of a company’s core earnings power. This method is also handy for valuing infrastructure companies.

Price-to-earnings ratio – one of the most commonly used valuation methods for stock analysis. P/E ratios are used when companies have relatively stable earnings and there are a number of comparable companies in the local market. Banks are often valued according to P/E ratios.

Net realisable value – is used for stock analysis when things get gloomy. An analyst will value a company according the amount the company’s assets are worth if sold (rather than the earning these assets generate) when the company is making sustained losses or is close to liquidation.

These methods mentioned above are all types of fundamental analysis, the pursuit of getting to the “fundamental” heart of a stock and analyse its worth.

Fundamental analysis observes the way a company runs – analysing the financial data that is “fundamental” to a company – its earnings, its profits, its dividends.

On the other hand, many traders instead use technical analysis, which involves analysis of stock charts in order to determine an understanding of the way prices move.

There is no “right” way in terms of approaching stock analysis, though most analysts will use a combination of both fundamental and technical analysis in their approach.

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In stock analysis, Japanese candlesticks are one of the most popular ways to display price information which includes the open, close, range and direction of trade for trading instruments such as equities and currencies. It was known to be developed by Homma Munehisa, a successful Japanese rice trader in the 18^th century.  The Japanese Candlestick makes price charts visually easy to read and understand, making it a favourite amongst traders, chartists and technical analysts.

A Japanese Candlestick resembles an upright rolling pin as it is composed of a body and two wicks (or shadows) on each side of the body.

The body represents the opening and closing price for the period. If the instrument closed higher than it opened, the candlestick should often be a white, blue or green colour to highlight an upward movement over the specified period. If the instrument closed lower than it opened, it should represent a black or red coloured body.

The wicks above and below the body (if it exists) represent the price range the instrument has traded over the specified period.  The longer the wicks, the larger the range the price of the instrument has traded.

How are they used?

Candlesticks can formulate different price patterns which can be used to help predict the trend of a security, and this is an important concept in stock analysis. There exist specific names that are attached to different types of candlesticks that display different lengths of body and wicks. Generally, they can be used as a timing tool to get into or get out of a trade.

A bullish signal is usually given if the lower wick is much longer than the upper wick, known as a ‘long lower shadow’ while a bearish signal is usually given if the upper wick is much longer than the lower wick, known as the ‘ long upper shadow’.

Additionally, if a bull run would follow a ‘long lower shadow’, it would be reflected by higher highs and higher lows as well as candlesticks with white bodies without wicks which are called ‘white marubozus’. Conversely in a bearish market, a downtrend would be represented by lower highs and lower lows with perhaps black bodies without wicks known as ‘black marubozus’ occurring after a ‘long upper shadow’.

So, when conducting stock analysis using charts, remember that Japanese candlesticks provide more information about price patterns than a normal line chart.

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One common way to classify stocks is to make an assessment as to whether they are “cyclical” or “defensive”.

These two terms represent, as you can probably guess, two types of industry or stock that are at stark odds with the other.

Let’s take a deeper look at what these terms mean, and how they interplay with the stock market.

The terms cyclical and defensive are used to show how closely correlated a company’s share price, or a sector’s performance, is to fluctuations in the economy.

Cyclical stocks are those whose fortunes are tied to the strength of the economy. They perform well when the economy is strong, and will decline when the economy is performing badly.

In other words, cyclical stocks perform according to the big picture, where as defensive stocks generally perform solely on their own merits.

In general, defensive stocks tend to offer more steady products and services. Business doesn’t necessarily boom when the economy is strong, but also doesn’t suffer too badly when the economy is struggling.

Defensive stocks are non-cyclical because they experience solid profits regardless of the motions of the broader economy.

Defensive stocks, as we noted above, are not considered to be tied to the market. However, their fortunes are still party tied to how the broader economy is going.

Defensive stocks are seen as safer, and should perform better in a bear market. Even if they don’t manage to go up during a bear market, they shouldn’t fall by as much as cyclical stocks in bad times.

Because defensive stocks and cyclical stocks are polar opposites, when cyclical stocks are doing poorly, defensive stocks tend to do well.

An example of defensive stocks to choose in a bear market would include those that are in the healthcare industry, namely CSL Limited which is a biopharmaceutical company.

Additionally, other sectors that are generally considered most defensive in a bear market are officially known as the consumer staples and the utilities.

Generally, some experts believe defensive sectors include industries such as drugs, healthcare, information technology and food on a wider spectrum.

Defensive stocks are defensive in nature because the demand for them tends to be strong no matter how the general economy is performing. This is because defensive stocks produce items considered necessities, and product demand should continue regardless of the big picture.

For instance, people will always need electricity in their homes, so utilities companies tend to perform steadily over time; it’s not like you will buy twice as much electricity when times are good!

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