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Focus on Fundamentals First

Focus on Fundamentals First

Some traders discount the value of fundamental analysis—the study of a company’s financial statements, management, competitors and other factors—to help determine a stock’s value. Perhaps they think fundamental analysis is primarily for the long-term and doesn’t help with shorter-term trading. But understanding the health of the underlying business and its prospects can help support—or scuttle—the case for a potential trade.

Using fundamental analysis alongside technical analysis—the study of market activity, including past prices and trading volume—can be a powerful combination. Fundamental analysis can help with security selection, or “what to buy,” while technical analysis can help answer the question of “when to buy” by focusing on supply and demand for shares.

So how should traders think about fundamental analysis? It can be useful to divide it into two groups of factors: Growth factors are good indicators of a business’s health and can help signal where it’s headed. Value factors can help you determine whether a stock’s market valuation is appropriate. Here we’ll look at both and discuss how you might use them when you trade.

Narrow your list

Before performing fundamental analysis you have to pick your stocks. How you do this depends on whether you tend to research stocks from the bottom up or top down. With the former approach, you identify a stock through technical analysis or other means and then use fundamental analysis to see how it stacks up to its peers and industry benchmarks.

With the latter approach, you identify a sector of the market that appears ripe for appreciation and then use a stock screener to narrow the choices down to a manageable list of candidates for fundamental analysis.

Another way to screen stocks would be to look at those that score highly in Schwab Equity Ratings® or Schwab Industry Ratings™. You could also focus on stocks that meet minimum thresholds for average daily volume or market capitalization.

Once you’ve picked your stocks, it’s time to look at some fundamental criteria.

Growth factors

While the corporate structure is designed for growth, most companies aim to eventually turn a profit and maximize shareholder value. Whether a company is able to generate earnings and increase them over time is a key consideration for fundamental traders: Investors buy shares in publicly traded companies in the hope that the share price will rise as the value of the overall business grows, which is directly tied to a company’s ability to increase revenue and profits.

For this reason, many investors place a premium on a company’s historical growth rate and projected future growth rate, as well as other factors:

  • Historical growth refers to the annualized rate at which a company has increased its earnings per share (or revenue) over a given period. Many analysts consider consistent earnings growth to be the primary driver of a stock’s price over the long run. Publicly traded companies, even relatively new ones, report revenue and earnings on at least a quarterly basis.
  • Projected growth looks at the rate at which a company is expected to increase its earnings per share or revenue over some future period. Companies often provide future earnings and revenue guidance in conjunction with quarterly earnings reports. Brokerages and research analysts may also do their own calculations. Whether the company is beating or missing earnings estimates, and by what margin, can provide insight into the health of the underlying business.
  • Free cash flow tells you how much money the company generates after subtracting the capital expenditures required to grow the business. A company with strong free cash flow can develop new products, make acquisitions and pay down debt more easily than a company with weak cash flow.

These are just a few of the many growth metrics you might consider. You can also use more granular measures of performance—same-store sales, number of subscribers or new product sales are a few examples—for additional insights.

A company’s sector and age are also important. For example, same-store sales are a key metric in the retail sector but would be of little value when assessing a service organization. And looking at historical growth can help you determine how well an established company has adapted to changing trends within its industry, whereas projected revenue growth may be more appropriate when analyzing a new company.

Value factors

Not every company is able to consistently increase its earnings over time. Still, all companies have value as long as they continue to operate. A question for investors is whether a company’s current share price accurately reflects the true underlying value of the business.

You can look at several measures of value to assess a given company, and use them as a basis for comparing a company to its peers:

  • Price-to-earnings ratio (P/E) is a company’s stock price divided by its annualized earnings. It is the most common metric for gauging relative valuations of publicly traded corporations. If a company’s P/E is below what is normal for a given sector that may signal its stock is undervalued (and vice versa for a P/E that is higher than normal). You can calculate the P/E ratio on a historical basis (the prior four quarters of earnings) or on a forward-looking basis (using projections over the next four quarters). What is considered an “appropriate” P/E ratio varies by industry.
  • Price-to-book ratio (P/B) compares the present stock price to the amount that shareholders would theoretically receive if the company were liquidated. A stock that is trading below book value is typically considered to be undervalued—traders are willing to sell the stock for less than the company’s underlying value (in other words, for less than the sum of its parts). Like the P/E ratio, P/B ratios can vary by industry.
  • Price-to-sales ratio (P/S) compares the present stock price to the dollar amount of sales the company generates per share. The lower the P/S value, the more undervalued the stock.
  • Dividend yield measures the amount of dividends a company pays out relative to its share price. Many investors look to dividends as a way to generate income from their portfolios above and beyond share price appreciation. Investors generally favor companies that consistently increase dividends, as this indicates the company is comfortable with its cash flow. Some traders, by contrast, favor high-growth companies that often pay little or no dividends at all.

Fundamental analysis at work

Both growth and value factors can be useful—but in different situations.

Growth factors could be more revealing if you’re assessing smaller companies, especially new companies in the technology sector, because of their potential to increase sales and profits from a relatively low base. In some cases, a high rate of earnings or revenue growth may justify a high stock price valuation, particularly if the company has a competitive advantage in its market.

And generally speaking, a growth approach may prove more profitable when the overall market is on an upward trajectory.

Value factors could be more useful when it comes to assessing larger companies whose earnings growth rates have moderated, but remain dominant in their sectors. Instead of using all of their cash to reinvest for growth, such companies might look for opportunities to return excess capital to shareholders in the form of dividends, share buybacks or retirement of debt. Fundamental investors who are more conservative, either because they are approaching their financial goals or are simply more risk averse, might pay closer attention to such factors.

Traders may find a strategy that combines both factors to be the most effective in reducing volatility in their portfolios and generating gains. Some measures bridge the divide on their own. A stock’s PEG ratio—its price-to-earnings ratio divided by the growth rate of its earnings—often is considered a more complete assessment of a company’s current valuation than a P/E ratio because it takes earnings growth into account.

In any case, understanding fundamental analysis can help identify potentially profitable trading opportunities. You don’t have to be a buy-and-hold investor to benefit from a deeper look at the stocks you trade.

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The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision. Examples are not intended to be reflective of results you can expect to achieve.

Schwab Equity Ratings and the general buy/hold/sell guidance are not personal recommendations for any particular investor or client and do not take into account the financial, investment or other objectives or needs of, and may not be suitable for, any particular investor or client. Investors and clients should consider Schwab Equity Ratings as only a single factor in making their investment decision while taking into account the current market environment.

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