Buying stocks without understanding the underlying business is gambling. Fundamental analysis examines companies financial health, competitive position, and growth prospects to determine fair value. This approach separates informed investors from speculators riding momentum.
Warren Buffett built his fortune through fundamental analysis. He reads annual reports, calculates intrinsic value, and only invests when price falls well below that value. You can use these same techniques.
Core valuation metrics every investor needs
The price-to-earnings ratio compares stock price to annual earnings per share. A $100 stock earning $5 annually trades at a P/E of 20. Lower P/Es suggest cheaper valuations, though growth companies often command premium multiples.
Compare P/E ratios to industry averages and historical norms. Tech stocks typically trade at higher P/Es than utilities. A 25 P/E might be cheap for a software company but expensive for a bank.
Price-to-book ratio divides market cap by book value (assets minus liabilities). Stocks trading below 1.0 P/B sell for less than accounting value. This metric works well for asset-heavy businesses like banks and manufacturers.
The PEG ratio adjusts P/E for growth by dividing P/E by expected earnings growth rate. A stock at 30 P/E growing 30% annually has a PEG of 1.0. PEGs below 1.0 suggest the growth rate justifies or exceeds the valuation.
| Metric | Formula | What It Shows | Good Range |
|---|---|---|---|
| P/E Ratio | Price / Earnings per share | Valuation relative to profits | 10-25 for most stocks |
| P/B Ratio | Market cap / Book value | Price vs net assets | Under 3.0 typical |
| PEG Ratio | P/E / Growth rate | Valuation vs growth | Under 1.0 attractive |
| Debt-to-Equity | Total debt / Shareholders equity | Financial leverage | Under 1.0 conservative |
| ROE | Net income / Shareholders equity | Profitability efficiency | Above 15% strong |
Analyzing profitability and efficiency
Profit margins reveal how much revenue converts to profit. Gross margin subtracts cost of goods sold from revenue. Operating margin accounts for operating expenses too. Net margin shows final profit after all expenses and taxes.
Compare margins to competitors and watch trends. Expanding margins signal improving efficiency or pricing power. Shrinking margins warn of competitive pressure or rising costs eating into profits.
Return on equity measures how efficiently management uses shareholder money. Divide net income by shareholders equity. ROE above 15% indicates strong management. Companies consistently achieving 20%+ ROE are rare gems worth premium valuations.
Return on invested capital goes deeper than ROE by including debt. ROIC shows returns generated from all capital employed in the business. Companies with ROIC exceeding their cost of capital create value. Those below destroy it.
Evaluating financial health and stability
The current ratio divides current assets by current liabilities. Ratios above 1.5 suggest comfortable liquidity. Below 1.0 signals potential trouble paying short-term obligations. This matters most for companies with lumpy cash flows.
Debt-to-equity reveals financial leverage. Conservative companies keep this below 0.5. Ratios above 2.0 increase bankruptcy risk during downturns. Cyclical businesses should carry less debt than stable ones since their earnings fluctuate.
Interest coverage divides operating income by interest expenses. You want this above 5.0, showing the company earns five times its interest obligations. Below 2.0 means most profits go to servicing debt rather than growing the business.
Free cash flow matters more than reported earnings. Calculate it by subtracting capital expenditures from operating cash flow. Positive and growing free cash flow lets companies pay dividends, buy back stock, or fund expansion without borrowing.
Assessing competitive advantages
Economic moats protect businesses from competition. Strong brands, network effects, switching costs, and economies of scale create moats. Companies with moats maintain high returns on capital for decades.
Brand value provides pricing power. Apple charges premiums because customers trust the brand. Commodity products lack this advantage - buyers choose purely on price. Strong brands defend margins during competitive pressure.
Network effects grow value as more users join. Facebook becomes more valuable to users as more people join. This creates winner-take-most dynamics where leading networks dominate their markets.
Switching costs lock in customers. Enterprise software is expensive to replace once embedded in operations. Banks benefit because moving accounts is hassle. These moats generate predictable recurring revenue.
Calculating intrinsic value
Discounted cash flow analysis estimates a company's value based on projected future cash flows. Project cash flows for 5-10 years, estimate terminal value, then discount everything back to present value using an appropriate rate.
The discount rate reflects risk and opportunity cost. Use 10-12% for stable businesses and 15%+ for risky or cyclical ones. Higher rates produce lower valuations, building in a margin of safety.
Compare your calculated intrinsic value to market price. Only invest when trading at least 25% below your estimate. This margin of safety protects against calculation errors or unexpected problems.
Comparable company analysis looks at how similar businesses are valued. Find 3-5 competitors and examine their average P/E, P/B, and EV/EBITDA ratios. Apply these multiples to your target company to estimate fair value.
Dont obsess over precision. Valuation involves assumptions and estimates. Being approximately right beats being precisely wrong. Focus on companies trading at obvious discounts rather than splitting hairs over 5% differences.
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