Five Things to Understand About a Stock’s Fundamentals

By: Andrew McShane

Understanding the fundamentals of a stock can lay the foundation of successful investing

You are about to learn...

  • Which stock fundamentals are indicators of health
  • What Stock fundamentals mean for the direction of a stock
  • How fundamental analysis uses market capitalization
  • What to do if you have questions on stock fundamentals

Understanding stock fundamentals is critical if you are going to buy or sell stocks as an investor. When you buy shares of a company’s stock you become part owner of a business.

Understanding the health of the businesses you invest in by doing a fundamental analysis of the stocks you are thinking about buying is critical to becoming a successful investor.

Ignoring these stock market fundamentals will reduce your chances of becoming a successful investor. However, if you consider these five stock fundamentals before buying or selling a stock it should improve your investment returns.

Research the company of the stock you are considering investing in.

You would be surprised at the number of people that will buy a stock because their friend, barber or in-law told them to do so.

Don’t buy any stock until you’ve read as much information as possible from their website, as well as other sources.

Listen to the last two earnings conference calls to hear the company management talk about the business. Do they sound confident and upbeat about the business?

Certainly this kind of research takes time and not everyone has the time or the patience to do this work.

Remember this is your hard-earned savings you are investing, so take the time to do the research.  If you don’t have the time to do this research then find a different kind of investment for your money.

Fundamental analysis of stocks includes looking at the quarterly financial statements filed with the Securities and Exchange Commission.

While it is helpful to have a background in business or accounting to review the financial statements, even those without such training can look out for some basic signs of a healthy company:

  • Does the income statement show net income at the bottom to indicate profitability?

 A company that is losing money is not necessarily a bad investment, but it is a yellow flag.

For instance a newer company that is losing money as they try to get their business to scale would be an OK reason to show a net loss in the income statement. But if the company has been showing a net loss for too long a period of time, it might be time to look at a different company,

  • Does the statement of cash flows show a business that is generating cash or burning through cash?

A business that is spending more cash than it is bringing in is not necessarily bad, but companies that are generating large amounts of cash flows each year are more likely to be a better investment over the long run.

  • Does the balance show a lot of long-term debt that is coming due soon which could negatively impact the company and its stock price?

If the company has a lot of long-term debt coming due soon you need to make sure that the long-term debt will be able to be refinanced at attractive interest rates.

  • Does the statement of cash flows show the company paying a dividend which could increase your profit from owning the stock?

A company paying a dividend does not automatically make its stock a better investment. But if you are an investor who needs current income as part of your investment return, then you will need to focus only on companies that pay a dividend to its shareholders.

Stock fundamentals include looking at the market capitalization of the stock.

Market capitalization is readily available on most financial websites and is calculated by multiplying the current stock price by the number of shares outstanding.

It is a measure of the current value assigned to the company by investors.

On one hand Amazon has a very large market capitalization at over $1 trillion and on the other hand, so call “penny stocks” have a value that is typically much less than $100 million.

Think about the size company you want to invest in when you are doing your fundamental analysis of stocks.

4.Stock market fundamentals include looking at the direction that revenues and earnings are heading.

All things being equal a company will be valued higher if its revenues and earnings are growing on a consistent basis vs. one with stagnant or declining revenues and earnings.

One thing that Wall Street demands for its stocks to be richly valued is “growth”. Companies that have growing revenues and earnings (both historically and anticipated future growth) will be richly valued on a price to earnings or price to sales ratio.

Those that don’t have growth in sales and earnings will be valued much lower.

Fundamental analysis of stocks also includes looking at how many shares are traded each day.

Large market capitalization stocks have tens of millions of shares that trade hands each day.  Those kinds of stock are very safe to buy.

Very low market capitalization stocks sometimes only trade several thousand shares of stock each day. This can be dangerous because if you buy shares in this latter kind of stock you may move the price of the stock in a manner that is costly to you.

What to do if you have questions as you do your fundamental analysis of stocks

There is so much information available on most public companies that trying to sift through it and understand it in order to make an informed decision about investing can be intimidating. Especially for folks that are  a novice to investing in stocks.

If you don’t understand something, you should seek out a trustworthy CPA and/or financial advisor to help you better understand the information on the company you are considering investing in.

When in doubt, don’t invest. If it sounds too good to be true, it probably is. If after talking to a financial advisor you still don’t fully understand the company, don’t invest and instead move on to the next company for consideration.

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