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Trading Up-Close: Using Fundamental Analysis

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At its core, fundamental analysis answers two questions:

“How's the business doing" and “What is that business worth?” 

In other words, are the revenue and earnings growth improving, stable, or deteriorating, and what’s a reasonable price point for that company’s stock? 

If you’ve identified certain sectors and industries to invest in, then fundamental analysis can allow you to evaluate and compare multiple companies within those sectors and industries.

You can use fundamental analysis to weed out potentially weak companies, and focus on the ones with seemingly better financial strength. 

Earnings growth is a good place to start when you're choosing individual equities.

Keep in mind, when you buy stock in a company, you're looking to participate in the growth of the underlying business, as measured by earnings per share or EPS.

Screening for earnings growth makes it easy to filter out companies with declining or negative earnings.

Revenue or sales growth is another criteria that I like to use.

It’s often overlooked by many investors in favor of earnings growth.

Recently, however, many companies have grown earnings per share by cutting costs, stock buybacks, and tax breaks.

While this method of financial engineering can boost EPS in the short-run, this can only last so long, and at some point, companies have to grow sales in order to actually bolster future earnings.

This is why it's important to consider both earnings growth and revenue growth when using fundamental analysis filters.

Valuation is useful when comparing companies in similar sectors and industries because it gives you a good apples-to-apples view. 

Since the return on your investment will partially depend on purchasing a stock at a reasonable price, valuation measures such as the price-to-earnings, price-to-sales, price-to-book value and price-to-earnings growth are important in helping you determine how much you’re willing to pay.

The financial strength of the company is also important to consider. 

And one of the primary measures of a company's financial strength is its debt-equity ratio, or its leverage ratio.

This measures the percentage of the company's total debt compared to its shareholders' equity—similar to a homeowner's level of equity compared to the size of the mortgage.

Lower is generally better, and a commonly used rule of thumb is to look for companies with a debt-equity ratio of less than 50%.

Incorporating these tools can help you screen for companies with good growth potential, reasonable prices, and strong balance sheets allowing you to make more informed investing decisions.

Fundamental analysis is one of two primary ways to evaluate equities. Joe Mazzola, our Managing Director of Trader Education, looks at the primary factors traders can use to analyze the financial strength of companies and compare them to others in the same industry or sector.

What you can do next 

 

Important Disclosures

This video is made available for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned may not be suitable for everyone.

Schwab does not recommend the use of fundamental analysis as a sole means of investment research.

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