Thousands of potential choices can make it challenging for traders filtering the market trying to decide which new companies to consider. Using fundamental analysis can help you narrow the search, weed out poor candidates, and focus on the companies that display financial strength. At its heart, fundamental analysis is the answer to a simple two-word question: "How's business?" In other words, is the underlying business's revenue growth improving, stable or deteriorating?
Fundamental analysis tools
These four fundamental analysis tools can be useful for evaluating market indexes and individual stocks.
Earnings growth—This should be one of the most important criteria when you're choosing individual equities. When you own stock, you're participating in the growth of the underlying business, as measured by earnings per share (EPS) growth. Earnings growth can be measured over different time frames, such as year-over-year (YOY) or as a five-year average.
Using earnings growth as a screening criterion makes it easy to filter out those companies with declining earnings or negative earnings growth.
Revenue (sales) growth—In recent years, many companies have grown earnings by cutting costs. However, costs can only be cut so much, and at some point companies have to grow sales in order to grow future earnings. This is why it's important to consider both earnings growth and revenue growth when using fundamental analysis filters.
Valuation—If earnings growth and sales growth were the only factors that mattered, choosing individual equities would be much easier. However, your return partially depends on purchasing a stock at a reasonable price. Valuation measures, such as the price-earnings ratio or price–book value ratio, may help you avoid overpriced stocks.
Financial strength—One of the primary measures of a company's financial strength is the debt-equity ratio. This measures the percentage of the company's total capitalization that's owed to others (i.e., debt) versus shareholders' equity—similar, for example, to a homeowner's level of equity compared to the amount of his or her mortgage. Lower is generally better, and a reasonable rule of thumb is to look for companies with a debt-equity ratio of less than 50%.
Filtering the market, sectors and ETFs
Keep in mind that the overall rate of growth in the economy will impact earnings growth in the various sectors and, as a result, in the exchange-traded funds (ETFs) representing those sectors.
Also note that some sectors (including Consumer Discretionary, Basic Materials, Industrials and Technology) are more economically sensitive, which means that they respond well to a growing economy and poorly to a recessionary one. Other sectors (such as Consumer Staples, Health Care and Utilities) are less sensitive to changes in the economy. Because of these differences, the growth rates for earnings and sales, as well as the relative valuation levels, will vary between sectors—perhaps considerably.
As a result, screening for absolute levels of growth or specific valuation metrics may lead you astray. Screens that look for high EPS and revenue growth could exclude the less economically sensitive sectors and the companies within those sectors. On the other hand, screens for low valuations could leave out the more economically sensitive and rapidly growing sectors and companies.
It's important to compare "apples to apples" on EPS, revenue growth and valuation measures by comparing a specific company to others in its own sector and/or industry.
Once you have built a screen and narrowed down your list of candidates, create a watch list. You can sort your watch list in different ways—for example, by the dividend yield of each stock. Even if dividend yield was not part of your original screening criteria, by using this metric you can focus your initial research efforts on the stocks that have the highest yields.
Remember that screening merely produces a list of companies that meet certain criteria. Actually researching each company, first with fundamental analysis followed by technical analysis, may help you form better opinions about which stocks to add to your portfolio.
With a few basic filters, you can effectively narrow the market from thousands of stocks to a qualified short list that meets specific criteria. Use the fundamental analysis tools above to scan the whole market and make more objective decisions about what to consider adding to your portfolio.