Fundamental Analysis: the Basics

TL;DR: Fundamental analysis means looking at a company's numbers: revenue, profit, debt and cash flow. You use them to estimate what a share is worth. It helps you understand a company, but it does not predict the price.

Step-by-step guide

1. Find the annual report and half-year results on the company’s investor relations page.
2. Look at revenue over the past 3 to 5 years: is it growing or shrinking?
3. Look at profit margins and compare them with competitors in the same sector.
4. Calculate the price-to-earnings ratio and compare it with the sector and with the company’s own history.
5. Look at debt: can the company pay its interest and repayments?
6. Look at cash flow: does the company have money left after investments?
7. Note warning signs: falling revenue, rising debt, shrinking margins.
8. If you like, combine your findings with technical analysis, and decide in advance how much you are willing to lose at most.

The price-to-earnings ratio

The price-to-earnings ratio (P/E) shows how much investors pay for 1 euro of profit.

P/E = price per share / earnings per share

Example: a share is at €100 and earnings per share are €5. Then the P/E is 100 / 5 = 20.

How do you use the P/E?

• Compare with companies in the same sector. A software company and a supermarket naturally have different P/Es.
• Compare with the company’s own history.
• Look at growth too. A higher P/E can fit a company that is growing quickly. The PEG ratio divides the P/E by expected yearly profit growth in percent. With a P/E of 20 and 10% growth, the PEG is 20 / 10 = 2.

Example: the low P/E trap

Suppose share X is at €60 and earnings per share are €6. The P/E is then 10. The sector averages 15, so at first sight X looks cheap. But its revenue has been falling 8% a year for years. The low P/E may then be a sign that investors expect further falls. A low P/E is a reason to look further, not a reason to buy.

Revenue and margins

Revenue is what a company sells. Profit margin is what is left after costs. You want to be able to follow both over several years.

A worked example with company Alfa (made-up figures):

• Revenue: €500 million
• Cost of sales: €300 million, so gross margin = (500 - 300) / 500 = 40%
• Operating profit (profit before interest and tax): €75 million, so operating margin = 75 / 500 = 15%
• Net profit: €50 million, so net margin = 50 / 500 = 10%

No margin is ‘good’ everywhere. Margins differ greatly by sector, so compare with competitors. Pay special attention to the trend: if margins fall year after year, the company is under pressure.

Debt and liquidity

Debt is not bad in itself, but too much debt makes a company vulnerable when revenue falls. Three commonly used figures, still with company Alfa:

• Debt-to-equity = total debt / equity. With €300 million of debt and €600 million of equity, that is 0.5. The higher the number, the more the company runs on borrowed money.
• Current ratio = current assets / current liabilities. With €120 million and €80 million, that is 1.5. Below 1, the company may struggle to pay its bills in the short term.
• Interest cover = operating profit / interest costs. With €60 million and €12 million, that is 5. The company then earns 5 times its interest costs.

Normal values differ by sector here too, so compare with competitors.

Free cash flow

Profit is an accounting figure. Cash flow shows how much money really comes in and goes out.

Free cash flow = cash flow from operations - investments

At Alfa: €90 million - €40 million = €50 million. If Alfa has a market value of €1,000 million, the free cash flow yield is 50 / 1,000 = 5%. A positive and growing free cash flow is usually a good sign. A company that reports profit year after year but has negative free cash flow deserves extra attention: it may need to raise money from investors or borrow to keep going, which can weigh on the price.

Where do you find the numbers?

• The company’s investor relations page (annual report, half-year results, presentations).
• The financial pages of your broker or of financial websites. Always check important figures in the original report.
• For Dutch and European companies listed on Euronext, reports are usually on the company’s own website. Collect several years so you can see a trend.

Limitations

Fundamental analysis gives no price guarantee. Numbers look backwards, while the price mainly looks forward. Reports can follow different accounting rules, which makes companies hard to compare. And a share that looks cheap can stay cheap. Use it as a tool to understand better what you are buying, and spread your risk across several investments. You can find more about stocks on our page for that category.

Investing involves risk: you can lose all or part of your money. Past performance is no guarantee of future results. This tutorial is information, not investment advice.