Fundamental analysis is the process
of examining a company's financial statements
to help decide if its stock is a good investment.
Financial statements include balance sheets,
income statements, and cash flow statements.
This information helps determine the financial makeup
of the company behind the stock.
In this video, we'll explain how fundamental analysis
uses these statements to help evaluate a company.
Let's start with a balance sheet.
This document compares the company's current assets
to its liabilities and owner's equity.
Let's define these terms.
First, we have assets, which are items the company owns.
Assets are usually comprised of cash, equipment, and property.
Next are liabilities.
Liabilities are usually debts or accounts that need to be paid.
Often, a liability on the balance sheet
has an offsetting asset that helps the numbers stay level.
For example, if a company were to take a loan out
to buy a property, the loan would be a liability,
and the property would be an asset.
The third term of a balance sheet
is capital or owner's equity, which
is the amount of assets raised by issuing stock.
For example, when a company issues stock
either in its initial public offering
or in a secondary offering, it raises money or capital
that can be used to fund various business expenses.
Balance is achieved when the value of the assets
are equal to liabilities and owner's equity.
The balance sheet helps you see how a company raises money
for its assets and can help you determine
if the company is overextended.
However, if you want to know how the company earns money,
you'd look at its income statement.
An income statement shows a company's revenues
and expenses.
These are the costs associated with running
the business, including operations, interest
paid on loans, and taxes.
When you take revenues and subtract expenses,
you get net income.
Net income is the earnings of a company.
Earnings are usually handled in two ways.
The first way is to share the earnings with shareholders
by paying a dividend.
The second way is to reinvest these earnings
into the company.
Reinvesting earnings can help a company's cash position.
A company with a good cash position
is usually better prepared to endure economic ups and downs.
This is why some investors say cash is king.
It's also why the cash flow statement is an important item
to consider.
This statement shows how the company
uses its cash to operate the business and make investments.
It also shows how much is borrowed
from a bank or a bondholder.
These figures are totaled to show changes in the company's
overall cash position.
This statement is important because it
gives a more detailed account of how the business generates
revenue, and is therefore much more difficult to manipulate
than an income statement.
As you can see, there is a lot of information in the three
financial statements.
With all of these facts and figures,
analysis can be a little tricky.
This is why some investors may use ratios.
There are several ratios that can help an investor compare
stocks, but we'll focus on one of the most common, the price
to earnings or P/E ratio.
Let's say you have one stock that's trading at a $6 share,
another at $35 a share, and a third at $132 a share.
How would you know which one is the best value?
Some might assume the $6 stock is the best value, because it's
the cheapest.
However, this might not be the case,
because a company's value may depend largely
on the company's earnings.
The P/E ratio allows you to look beyond the price of a stock
to see which company could be the best value.
To create this ratio, first divide the net income
or earnings by the number of outstanding shares.
This number is called Earnings Per Share or EPS.
Next, divide the price of the stock
by the EPS to get the P/E ratio.
The first company is trading at $6 and has an EPS of $0.20,
resulting in a P/E of 30.
The second company is trading at $35 a share and has an EPA
of $1.40 for a P/E of 25.
The final company is trading at $132 per share and has an EPA
of $3.90 for a P/E of 34.
Now, you can better compare each company by its P/E ratio.
Despite the drastic difference in stock prices,
all three companies have a similar valuation.
However, the second company has the lowest P/E ratio
and may be the best value.
Remember, a P/E ratio is only one of several ratios
that can be used.
There are other ratios for determining
valuation, profitability, and financial strength.
There are also other figures to examine
in financial statements.
We've only scratched the surface of fundamental analysis
in this video.
It's important that you learn more before using this analysis
to make a trade, and we're here to help
you every step along the way.
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