Investing Basics: Fundamental Analysis

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Narrator: Fundamental analysis is the process of examining a company's financial statements to help decide if its stock is a good investment.

Financial statements include balance sheets, income statements, and cash flow statements. This information helps determine the financial makeup of the company behind the stock.

We'll explain how fundamental analysis uses these statements to help evaluate a company.

Let's start with the balance sheet. This document compares the company's current assets to its liabilities and shareholders' equity. Let's define these terms.

First, we have assets, which are items the company owns. Assets are usually comprised of cash, equipment, and property.

Next are liabilities. Liabilities are usually debts or accounts that need to be paid.

Often a liability on the balance sheet has an offsetting asset that helps the numbers stay level. For example, if a company were to take a loan out to buy a property, the loan would be a liability and the property would be an asset.

The third term of a balance sheet is capital or shareholders'' equity, also known as "book value".  Shareholders' equity is the amount of money that would be left to shareholders if the company shut down and sold its assets and paid all its liabilities. If you subtract a company's liabilities from its assets, you will have the shareholder's equity.

On-screen disclosure: Stock trading involves high risks, and you can experience a significant loss of funds invested.

Balance is achieved when the value of the assets is equal to liabilities and shareholders' equity.

The balance sheet helps you see how a company raises money for its assets and can help you determine if the company is overextended.

However, if you want to know how the company earns money, you'd look at its income statement.

An income statement shows a company's revenues and expenses. These are the costs associated with running the business, including operations, interest paid on loans, and taxes.

When you take revenues and subtract expenses, you get net income.

Net income is the earnings of a company. Earnings are usually handled in two ways. The first way is to share the earnings with shareholders by paying a dividend. The second way is to reinvest these earnings into the company.

Reinvesting earnings can help a company's cash position. A company with a good cash position is usually better prepared to endure economic ups and downs.

This is why some investors say, "Cash is king." It's also why the cash flow statement is an important item to consider.

This statement shows how the company uses its cash to operate the business and make investments. It also shows how much is borrowed from a bank or bondholder. These figures are totaled to show changes in the company's overall cash position.

This statement is important because it gives a more detailed account of how the business generates revenue and is, therefore, much more difficult to manipulate than an income statement.

As you can see, there is a lot of information in the three financial statements. With all these facts and figures, analysis can be a little tricky. This is why some investors may use ratios.

There are several ratios that can help an investor compare stocks, but we'll focus on one of the most common: the price-to-earnings, or P/E, ratio.

On-screen disclosure: For illustrative purposes only. Not a recommendation of any security or strategy.

Let's say you have one stock that's trading at $6 a share, another at $35 a share, and a third at $132 a share.

How would you know which one is the best value? Some might assume the $6 stock is the best value because it's the cheapest.

However, this might not be the case because a company's value may depend largely on the company's earnings.

The P/E ratio allows you to look beyond the price of a stock to see which company could be the best value.

To create this ratio, first divide the net income, or earnings, by the number of outstanding shares.

This number is called earnings per share, or EPS.

Next, divide the price of the stock by the EPS to get the P/E ratio.

The first company is trading at $6 and has an EPS of $0.20, resulting in a P/E of 30.

The second company is trading at $35 a share and has an EPS of $1.40 for a P/E of 25.

The final company is trading at $132 per share and has an EPS of $3.90 for a P/E of 34.

Now, you can better compare each company by its P/E ratio.

Despite the drastic difference in stock prices, all three companies have a similar valuation.

However, the second company has the lowest P/E ratio and may be the best value.

Remember, a P/E ratio is only one of several ratios that can be used. There are other ratios for determining valuation, profitability, and financial strength.

There are also other figures to examine in financial statements. We've only scratched the surface of fundamental analysis in this video. It's important that you learn more before using this analysis to make a trade. And we're here to help you every step along the way.

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