Fundamental Stock Analysis Guide

The Financial Fresher
Jun 3, 2023
6 min read

Stock analysis can be overwhelming and daunting, provoking many to avoid investing into a singular stock and instead opting for large index funds. That is why I have created this guide.

Fundamental stock analysis is where we research data in order to determine what a company is worth relative to the market price, essentially helping us discover whether it is overvalued or undervalued.

It is important to note that the market price is volatile in the short term, however the value of a stock changes over the long term, so in order to find an undervalued stock we must find a deviation between the market price and the company‘s value, which would present a buying opportunity.

Remember, we want to buy from the pessimists and sell to the optimists, and be greedy when others are fearful and be fearful when others are greedy.

So lets begin…

Hint 1: Price to Earnings (PE) ratio

How to calculate: Market price/annual EPS

Definition: the PE is how much as an investor you are willing to pay for $1 of company earnings

Note: different industries and sectors have varying levels of normality, for example in the construction materials industry, the average PE is 22 (2018 est) whereas in the semi conductors industry the average PE is 80 (2018 est). This is because the projected growth for the semi conductor industry is much higher than that of the construction materials industry.

So how do we use PE when analysing a stock?

1. Compare to competition

e.g. JPM (JP Morgan) has a PE of18.4 whereas BAC (Bank of America) has a PE of17.7

2. Compare to market average

E.g. APPL = 18.3, whereas SPX500 = 25.7

Lower=cheaper

Flaw of PE ratio?

-doesn’t calculate anticipated growth into that number

E.g. tech company A has PE ratio of 25 and anticipated growth rate of 5%

Tech company B has PE 75 and anticipated growth rate of 20%

Issue is that the PE ratio suggests tech company B is more expensive than A, but considering the growth potential you notice you cannot compare

So PE:G is more effective when analysing a stock

As a result of the flaws of PE ratio, in my opinion, there are 2 ratios more useful than PE ratio:

1. PE:G ratio

Calculated by doing:

PE ratio/anticipated 5year growth

If PE:G under 1-> undervalued

If over 1 -> overvalued

If 1 -> fairly valued

Warning: during a bull market unlikely to find a PE:G under one as many stocks become overvalued so more useful during a bear market

Example (PE:G)

QCOM = 1.22

NVDA = 4.06

Result: QCOM overvalued but not to same ext as NVDA

This is how stocks begin to be traded on a speculative basis as all the future anticipated growth gets priced into the stock which causes the stock to be priced for perfection.

So if the stock faces a serious issue, the stock can fall by a large amount because the future anticipated growth was anticipated into that number before the issue.

2. Forward PE

Forward PE calculated by: Market price/predicted EPS

Used to help determine how much of the future anticipated growth is priced in today or if a stock appears to be overvalued with a high PE ratio then it might be because the forward PE ratio is expected to be much lower

E.g. AMZN PE = 247

AMZN forward PE = 99

Means u pay $247 per $1 of earnings and in future expect to pay $99 for $1 of earnings

Important to note forward PE and PE:G are based on expectations which do not always become reality so consider fact its not a guarantee

Hint 2: Dividends

The next tool to help analyse a stock is how they manager their dividends.

Important to note the following regarding dividends:

Dividend history (how long have they been paying it?)
Dividend growth streaks (how many years has the dividend been growing for?)
Dividend yield (how much they are paying to shareholders?)
Can a company afford their dividend (check dividend coverage ratio as seen below)

Why do company’s give dividends?

If a company is at a high stage of growth they will reinvest earnings rather than offering dividends (for example Amazon offer little dividends as at a high growth stage)
If a company’s growth has plateaued or they are just consistent they are likely to offer dividends (for example AT&T have a yield of 5.3% but do not have much growth)

Dividend Coverage Ratio

Calculated by: annual EPS/Annual dividend per share

Case study example - AT&T 2017

Annual EPS = $4.76

Annual DPS = $1.97

So the dividend coverage ratio was 2.4

So whats the ideal dividend coverage ratio?

Between 1 and 1.5 = not great dividend coverage so may need to cut in future

Smaller than 1 = poor as company pays more in dividends than they earn

Between 2 and 3 = ideal as earn more than they pay in dividends

Greater than 3 = greedy as company retains most of their earnings - it is important they reinvest them and do not waste them

High dividend trap case study:

Spark energy

PE 11.8, div yield 7.6% (this is misleading)
Coverage ratio is 0.37
2017 earnings $3.5m, dividends cost $9.5m
So total deficit was $6,000,000
CUT THE DIVIDEND

Hint 3: Financial documents

There are 3 main documents to focus on: income statement, cash flow statement, and the balance sheet

1. Income statement

Main factors to consider when analysing the income statement:

Is revenue increasing?
Is the cost of revenue growing at a faster rate?
Is gross profit keeping up?
Are there any significant jumps in operating expenses?
Is NET income increasing?

*Net income = revenue - expenses

2. Balance sheet

What does it do?

Compares assets to liabilities
Asset = an economic resource
Liability = a financial debt

Key factors to note when analysing the balance sheet of a company:

Total assets>total liabilities?
Short/long term debt coverage?
Assets growing or shrinking? (Ideally want double digit figures for asset growth YoY)
Liabilities growth rate/assets growth rate - we want similar growth, not a situation where liabilities are significantly outgrowing assets as we would not be able to pay them off
Type of debt? - is it short or long term? Check coverage ratio to see if company is able to pay it off
Cash cow? - is company sitting on a lot of cash to prepare for a acquisition? Or is company burdened with debt meaning little cash. We want to find a balance between lots of debt and too little debt. Too little debt may illustrate complacency and a lack of efficiency as debt can be used as a tool to fuel growth, in moderation
Stockholders equity growing? - we want double digit growth if a growth stock

3. Cash flow statement

There are 3 different sections within statement: financing, operating, and investing

Section 1: Operating activities (cash generated from sales of goods/services)

Is cash flow from operations increasing?
Inflows -> receipts
Outflows -> payments

Section 2: Investing activities (cash gains and losses from investing)

Section 3: Financing (shows inflows/outflows from activities like dividends (outflow) and issuing bonds to raise capital (inflow)

So how can we use the statements to analyse a stock?

Primarily through financial ratios…

There are 7 financial ratios, with 3 being split into liquidity ratios and the remaining 3 being split into margin ratios.

Liquidity ratios -> display company’s ability to pay back debt:

Current ratio - 120-200% (If above 100% it means they have coverage of short term liabilities)
Quick ratio - 75-100%
Cash ratio - 50-100% (shows u how much coverage cash and cash equivalents have on current liabilities or short term debt. Unlikely cash equivalent would ever be +100%)

Margin ratios -> illustrate company’s ability to generate income relative to costs

Gross margin (25%) - money company has before paying operating expenses, it includes COGS
Operating margin (25%) - how much a company makes before paying interest and taxes on each dollar of revenue
Profit margin (20%+) - how much each company earns on each $1 on sales
Return on equity (15%+) - shows u post tax profit generated by a company with the money invested by shareholders

There you have it, the starting steps you need to undertake a fundamental stock analysis.

Here is a brief checklist:

Reasonable PE/PEG/Forward PE across all three ratios
Dividend coverage ratio 2-3
Rev growing faster than cost of rev (or at least equal)
GP increasing
Short/long term debt coverage on balance sheet
Asset/liability growth rate
Are they a cash cow - look at the cash flow from operations and the cash and cash equivalents growth rate on balance sheet
Stockholders equity growth rate (10%+)
Cash flow operations growth
Current ratio 120%+
Margins above 20% (trend)
ROE above 15% (trend)