How to Analyze Company Fundamentals - No BS Investing
Posted 335 views July 8, 2022, 10:00 - Elisabeth in Investing

How to Analyze Company Fundamentals

Analyzing company fundamentals is a key part of a complete fundamental analysis for value investing.

A fundamental analysis helps you make an educated guess on a company’s cash flows based on how you think the company, industry, and economy will perform. You then determine what the company and stock are worth (and if it’s undervalued) to decide if you should invest. 

At a micro-level, you look at the company of the stock you want to invest in first. You want an overall picture of the company’s financial health (present and future). Here’s how to thoroughly analyze company fundamentals. 

Key Takeaways:

  • Choose a company you understand. Make sure you can easily explain what they do as a business.
  • Calculate financial ratios from the company’s financial statements to understand its performance, liquidity, etc. 
  • Review a company’s qualitative factors, including the business model, company management, and its competitive advantage. 

Step 1: Choose a company you understand

Before diving into any analysis, make sure you’ve selected a company so that you can easily explain what they do. As Warren Buffet says, “Never invest in a business you cannot understand.” 

Rather than choosing hot new stocks such as from tech companies that are difficult to comprehend, select value stocks in well-known industries. Some easy-to-understand value companies include:

  • Citicorp
  • JPMorgan Chase
  • Bank of America Corporation
  • Berkshire Hathaway
  • Procter & Gamble
  • Johnson & Johnson

These stocks might not be “sexy” but they are less risky and more established companies. Buffett avoids complicated businesses like technology companies altogether. He might have missed out on companies like Google and Amazon, but he lowered his risk by not investing in businesses he didn’t fully understand. 

Too often, people invest in companies they just don’t get. Consider investors who sank money into mortgage-backed securities during the housing bubble. Many of these securities contained low-quality loans. By not understanding what they were investing in, these investors lost a lot of money. 

Step 2: Calculate financial ratios from company statements

Once you’ve chosen your value companies, analyze quantitative factors about the company. Find the company’s financial statements such as the balance sheet, income statement, and cash flow statements. 

Use a free tool like last10k.com to access these statements. Type in the company’s ticker symbol in the search bar. Look at Item 8 on the company’s 10-K Annual Report for financial statements. From these statements, you can find data to calculate important financial ratios:

  • Working capital ratio
  • Quick ratio
  • Earnings per share (EPS)
  • Price-earnings (P/E)
  • Debt-to-equity
  • Return on equity (ROE)

Here’s how to calculate each ratio:

WORKING CAPITAL RATIO

Also known as the current ratio, the working capital ratio shows you the company’s ability to pay for current liabilities (e.g., rent payments) with its current assets (e.g., cash and cash equivalents). Here’s the formula:

Working Capital Ratio = Current Assets / Current Liabilities

Find current assets and liabilities in the company’s balance sheet. A good working capital ratio is typically between 1.5 and 2. Lower than 1.0 could mean liquidity problems in the future (aka quickly generating enough cash to pay off debt if needed). Compare a company’s working capital ratio with other companies in the same industry. 

QUICK RATIO

Similar to the working capital ratio, the quick ratio measures how well a company’s current assets could cover its current liabilities. 

But instead of looking at all assets like the working capital ratio, this ratio only looks at assets that can be converted to cash within 90 days or less. Here’s the formula:

Quick Ratio = Cash + Cash Equivalents + Current Equivalents + Short-Term Investments / Current Liabilities 

A quick ratio of more than 1.0 is considered less risky than a company with a quick ratio of less than 1.0.

EARNINGS PER SHARE

Earnings per share (EPS) is a calculation that shows how profitable a company is on a per-share basis. 

EPS = Net Profit / Total Number of Shares

A company is more likely to be profitable if it has a higher EPS. Compare the company’s EPS with the industry’s EPS (aka the peers) to determine if it’s good. 

PRICE-EARNINGS

This ratio shows if a stock is cheap (low P/E), fairly priced, or expensive (high P/E):

P/E Ratio = Current Stock Price / Earnings per Share

Here’s what it means: if a company has a P/E ratio of 10, investors are willing to pay $10 for every dollar it earns in profit. 

Compare your company’s P/E ratio to the market average P/E ratio which currently ranges from 20-25. A P/E ratio higher than that could be considered bad. A lower PE ratio could be considered safer. You normally look for a low P/E, but you need to take other ratios into consideration rather than using this ratio as your main investment factor. 

DEBT-TO-EQUITY

Debt-to-equity shows how much debt the company uses to run the business. Running off too much debt or borrowed money means that the company could go under if hard times hit. 

Debt-to-Equity Ratio = Total Liabilities / Total Shareholders’ Equity

A good debt-to-equity ratio depends on the industry, but between 1.0-1.5 is preferable. Over 2.0 shows that the company gets two-thirds of its capital financing from debt which can be considered risky. 

RETURN ON EQUITY

The return on equity (ROE) measures the profitability of a company. It shows how effectively a company uses its equity (aka the value of the shares issued by a company). 

ROE = Net Income / Shareholder’s Equity

Although a healthy ROE depends on the company’s industry, an ROE above 15% is considered good. However, a healthy ROE can vary depending on the business’s industry.

Hint: Simplify this process. Instead of calculating manually, use a tool like Investing Pro Plus to automatically view key financial ratios. 

Step 3: Review company qualitative factors

Numbers aren’t the only important factors when analyzing company fundamentals. Review the following qualitative factors:

BUSINESS MODEL

A company’s business model refers to a company’s plan for making a profit. Understand how the business generates value for its customers. Citigroup, for example, generates revenue by providing various banking products and financial services to individuals, businesses, and government entities.

COMPANY MANAGEMENT

A company might have a stellar product or service but that doesn’t mean much if the company’s management is poor. 

Review the company’s website, news articles, etc. Check up on the company’s CEO and other executive members to understand if their interests align with their stakeholders and if they make good business decisions. 

For example, value company Berkshire Hathaway’s executive team includes Warren Buffet. His past decisions indicate that company management is strong. 

COMPETITIVE ADVANTAGE 

See how the company’s product or service compares with similar items on the market. Can it sustain its competitive advantage over time? Examples of competitive advantages include:

  • Quality
  • Brand
  • Distribution
  • Network

For example, Johnson & Johnson’s competitive advantages are massive size, scale, and intellectual property library. Select companies whose competitive advantage will still be around twenty years from now. Look at the company’s long-term prospects. 

Use this analysis to make sure you’re investing in a good business. 

Use a tool to simplify analyzing company fundamentals

The main drawback to analyzing company fundamentals and completing an entire fundamental analysis is that it’s very time-consuming. 

You can use a fundamental analysis tool to simplify the process. We recommend Investing Pro Plus. This tool helps you easily evaluate stock fundamentals. Sign up for a free trial for Investing Pro Plus here

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Elisabeth O. is an MBA graduate with a specialization in International Finance & Investments and over six years of financial writing experience. She is passionate about long-term investing to build wealth, avoids day trading and speculations, and loves a good Warren Buffet quote.