Investing Basics: Fundamental Analysis

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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.

In this video, we'll explain how fundamental analysis

uses these statements to help evaluate a company.

Let's start with a balance sheet.

This document compares the company's current assets

to its liabilities and owner's 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 owner's equity, which

is the amount of assets raised by issuing stock.

For example, when a company issues stock

either in its initial public offering

or in a secondary offering, it raises money or capital

that can be used to fund various business expenses.

Balance is achieved when the value of the assets

are equal to liabilities and owner's 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 a 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 of 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.

Let's say you have one stock that's trading at a $6 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 EPA

of $1.40 for a P/E of 25.

The final company is trading at $132 per share and has an EPA

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.