Fundamental analysis is the name given to valuing stocks based on the company's underlying financials and performance.
This is different to technical analysis, which tries to predict a stock's future price movements based on trading patterns, market sentiment and chart analysis.
There are a couple of key metrics investors use to value stocks, like the P/E ratio (price-to-earnings).
How do you calculate the value of a stock?
Say you think you've found the next Tesla or Nvidia, but you aren't quite sure if you're about to strike stock market gold or ruin your portfolio.
Before you throw your life savings at it, you'd probably want to do some research into whether the stock is likely to go up in price or not.
That's where fundamental analysis comes in.
Fundamental analysis focuses on both the intrinsic and relative value of the shares to try and find the "true" value of a certain stock, based on the company's fundamentals – that is, its earnings, debt and other financial information.
In the immortal words of Warren Buffett, "price is what you pay, value is what you get."
You can also calculate a company's share value by comparing it to that of other similar companies.
This is known as a stock's relative value.
For example, comparing the fundamentals and share price of Wesfarmers with Woolworths could help you determine if one of them is undervalued or overvalued.
Some investors combine parts of both fundamental and technical analysis into their valuations.
In this guide, we'll be focusing on fundamental analysis as a way to value a stock.
You can check out the basics of technical analysis if you're keen to learn more about trading using stock charts.
How is a stock price actually determined?
The easiest way to calculate the price of a certain stock is by using a basic share price formula.
This means taking the market capitalisation of the company (the value of all shares added together) and divide it by the number of shares outstanding.
For example, say there's a Company X with a market cap of $1 billion that has 1 million shares. The value of each individual share of Company X would therefore be worth $1,000 ($1 billion divided by 1 million shares).
Of course, the actual price of a stock doesn't necessarily tell us much more about the value of the company or if it's likely to go up or down in future.
That's why we use fundamental analysis.
How do I perform fundamental analysis?
Investors use a number of different metrics and calculations to work out the fundamental value of a company and therefore if it's a good investment or not.
There are arguably 3 major ratios that are normally used to evaluate the value of stocks:
What it is: a way to value a stock based on the company's earnings.
How it works The price-earnings ratio (P/E) looks at a company's recent or forecasted earnings per share (EPS) against the current market price of its shares.
EPS is the portion of the company's profits (or earnings) allocated back to each individual share. You'll often see the term P/E with a number that is considered a "multiple" of the company's earnings, which is a result of the ratio applied.
To figure out a company's P/E, first look for its EPS figures, which will be readily available in the latest annual or quarterly report on its website.
Then simply divide the current price per share by the EPS to find the P/E.
Tip: If the company has adjusted EPS figures, use these instead as they will take into account any one-off major expenses for the reporting period that might affect the EPS figures.
Let's say company ABC has a current share price of $100 and an EPS of $10 as stated in its latest report. By using this formula, the company's P/E would be 10.
* This is a fictional, but realistic, example.
The P/E ratio works best when comparing apples with apples. Most investors would argue that a stock with a lower P/E than its peers is "cheaper" and could be undervalued.
For example, if you're considering 2 similar stocks in the financial industry and one has a P/E of 25 while the other has a P/E of 12, the latter would be considered as better value using this method alone.
What is considered a good P/B ratio? While there's no definitive P/E that's considered "good", over the last 40 years the ASX (Australian Securities Exchange) has averaged a P/E of around 151, which is sometimes seen as a broad threshold for fair value. In comparison, the S&P 500 has averaged a P/E ratio of 35 over the last 10 years2.
Some investors are cautious when a P/E ratio increases substantially, as investor expectations about the company's performance may have jumped ahead of the company's actual earnings growth. Investors might get caught up in the market hype and anticipate sizeable future growth, but if targets aren't then met, this could lead to the share price being overvalued.
Price-earnings to growth ratio (PEG)
What it is: a way to value a stock based on the company's expected earnings growth.
How it works
The price-earnings to growth (PEG) ratio considers a company's earnings growth. To figure this out, you'll need to find the company's estimated earnings per share over the next year, which will be included in its latest report.
To calculate the PEG ratio, use the P/E ratio and divide by the growth in earnings per share (EPS).
Continuing on from our example of company ABC above, let's say the company has an estimated EPS of $11 over the next year as stated in its report. This is an increase of 10% on its current EPS of $10. Using the PEG formula of the P/E (10) divided by growth in EPS (10%), we have a PEG of 1.
* This is a fictional, but realistic, example.
What is considered a good P/B ratio? Like the P/E ratio, the PEG ratio compares peer performance. While there's no set PEG ratio that is considered a definite "buy" signal, but fundamentalists may treat a stock with a PEG ratio below 1 as undervalued.3
Price-book ratio (P/B)
What it is: a way to value a stock based on the company's assets.
How it works Based on the underlying value of a company's assets, the price-book (P/B) ratio offers a snapshot of a company's value according to the book value of the assets on its balance sheet. P/B is calculated by dividing the current share price by the stock's book value divided by the number of shares issued.
The book value is worked out from the balance sheet as total assets minus total liabilities (or costs). The balance sheet with these figures is easy to locate in the company's latest earnings report on its website.
Consider company XYZ. Its market price is currently $2, with 50 million shares on issue. Total assets are $80 million and total liabilities are $20 million (this equals a book value of $60 million). The P/B ratio is: $2/(($80 million – $20 million)/50 million) = 1.7.
* This is a fictional, but realistic, example.
What is considered a good P/B ratio? The closer the P/B ratio is to 1 (or below), the greater the perceived value of the stock.4 P/B is mostly used for mature companies with limited growth.
What other fundamental metrics can you use to value stocks?
Here are some other examples of fundamental analysis that you can use to value a certain stock:
Dividend yield: The dividend yield is the distribution paid to shareholders as a percentage of the company's share value. A company with a strong track record of high dividend returns is often valued higher by investors.
Return on equity (ROE): This measure divides the net income of a company by the total shareholder equity and is used to measure a company's profitability and efficiency.
Debt-to-equity ratio (D/E): This ratio is calculated by dividing the company's liabilities by its total shareholder equity. It helps gauge how much debt a company is using to finance itself instead of its own capital.
VIDEO: How to do fundamental analysis
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How else can you value a stock?
As well as the above ratios that give you an idea of a stock's relative value in line with similar companies, here are a couple more tips to help you work out if a stock is fairly priced or not.
Broker recommendations. Major brokers such as Morgans, Bell Potter and Patersons or banks such as Goldman Sachs and JP Morgan release their own reports analysing certain companies. Their analyses include either a buy (or strong buy), sell (or strong sell) or hold recommendation based on where they think the share price is heading.
Broker price targets. Within these broker reports, they'll also include a price target for the company's shares. This is the price they believe the shares will reach within the next 12 months based on their own analysis of the company and the market as a whole.
While relying on these broker reports to determine intrinsic value or investment opportunities could be unwise, these reports may offer a broader picture of a stock's fundamentals.
It's important to note that using one of the methods outlined in this guide on its own to determine intrinsic or fair value isn't a sure-fire way of analysing an investment opportunity. The subjective nature of determining relative value will always lead to a variety of different opinions.
Instead, you would benefit from a combination of these methods as well as doing your own research into the company before making an investment decision.
Why should I value shares before buying?
No-one wants to pay more than they need to for something and we all love a bargain. The basic goal of investing in shares is to buy when the price is low and sell when it's higher in order to make a profit.
Valuing a company's shares against similar companies in the market is one of the easiest ways to do this.
It can help you work out if you're potentially paying too much for a stock, if you've found a bargain buy or if you're holding onto a potentially overvalued stock in your portfolio that you'd be better off selling and replacing with one of its competitors.
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Tom Stelzer is a publisher and writer for Finder, covering investing and cryptocurrency.
He previously worked for Finder as a writer in Australia and the UK, covering things like personal finance, loans, investing, insurance as well as small business and business loans.
He has a Master of Media Arts and Production and Bachelor of Communications in Journalism from the University of Technology Sydney. See full bio
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