Fundamental Analysis

Quick Answer

Fundamental analysis evaluates a company's intrinsic value using financial statements, earnings, assets, and economic factors, then compares that value to the market price. Analysts work top-down (economy to sector to company) or bottom-up (company first), and lean on ratios such as P/E, P/B, book value per share, payout ratio, and dividend yield.

The exam mostly tests whether you can match a tool or ratio to the fundamental-analysis toolbox and interpret what a given number implies about value. Memorize each formula's inputs, not just its name.

What Is Fundamental Analysis?

Fundamental analysis evaluates a security's intrinsic value by examining financial statements, earnings, assets, and economic factors. The goal is to determine whether a stock is overvalued, undervalued, or fairly valued relative to its current market price.

Focuses on the long-term investment outlook
Uses quantitative data (financial statements, ratios) and qualitative data (management quality, competitive advantage, industry conditions)

Top-Down or Bottom-Up: Where Does the Analysis Start?

Analysts reach a company's intrinsic value from two opposite directions:

Top-down - starts with the broad economy (e.g., GDP growth), narrows to a sector or industry, then evaluates individual companies within it
Bottom-up - starts directly with an individual company's own fundamentals (cash flows, earnings, management) and only later considers its sector or the economy

Exam Tip: Gotchas

Match the order given in the scenario, not whichever label the question uses. A scenario can walk through the analysis without ever saying "top-down" or "bottom-up," so identify the sequence yourself before answering.

What Financial Statements Feed the Analysis?

Income statement - revenue, net income, earnings per share (EPS)
Balance sheet - total assets, total liabilities, shareholders' equity, book value
Statement of cash flows - operating cash flow, free cash flow

\text{EPS} = \frac{\text{Net Income}}{\text{Shares Outstanding}}

Measures profitability on a per-share basis

What Does the Price-to-Earnings (P/E) Ratio Tell You?

\text{P/E Ratio} = \frac{\text{Market Price per Share}}{\text{EPS}}

Tells you how much investors pay per dollar of earnings
A P/E of 20 means investors pay $20 for every $1 of current earnings

Higher P/E	Lower P/E
Investors expect high future growth (growth stock)	Investors expect low growth (value stock)
May indicate overvaluation	May indicate undervaluation

P/E is relative - must compare within the same industry or sector

\text{Book Value per Common Share} = \frac{\text{Total Assets} - \text{Total Liabilities} - \text{Preferred Stock}}{\text{Common Shares Outstanding}}

Represents net asset value attributable to each common share
Subtract preferred stock (at par or liquidation value) first, because preferred holders have a priority claim on assets ahead of common shareholders
If the company has no preferred stock, the preferred term is zero and the formula reduces to total assets minus total liabilities, divided by common shares outstanding
Found on the balance sheet

What Does the Price-to-Book (P/B) Ratio Tell You?

\text{P/B Ratio} = \frac{\text{Market Price per Share}}{\text{Book Value per Share}}

P/B < 1: Stock trades below its book value (potentially undervalued, or market doubts asset quality)
P/B > 1: Market values the company above its accounting book value
Most useful for asset-heavy industries (banking, real estate)

Think of it this way: If P/B is below 1, the market is pricing the company at less than its accounting book value. That does not guarantee a profitable liquidation, since book value is an accounting measure and may not equal what the assets would actually fetch if sold.

What Is the Dividend Payout Ratio?

\text{Dividend Payout Ratio} = \frac{\text{Dividends per Share}}{\text{EPS}}

Measures the percentage of earnings distributed as dividends
A high payout ratio means the company returns most earnings to shareholders
A low payout ratio means the company retains more earnings for growth

What Is Dividend Yield, and How Does It Differ from Payout Ratio?

\text{Dividend Yield} = \frac{\text{Annual Dividend per Share}}{\text{Market Price per Share}}

Measures income return relative to what the stock costs today
The payout ratio instead measures income relative to what the company earns
Two companies paying the same dollar dividend can show very different yields simply because their share prices differ

Exam Tip: Gotchas

A high dividend yield is not automatically a bargain. An unusually high yield can be a yield trap: the market has priced in risk to the dividend's sustainability (a likely cut), not proof the stock is cheap. Do not treat "highest yield" as "best value" without checking why the yield is high.

Fundamental analysis examines the company and its financials. Technical analysis examines only price and volume data. The exam tests whether you can distinguish which tools belong to which approach. P/E, P/B, book value, payout ratio, and dividend yield are all fundamental analysis tools, never technical.

What Should You Check on Exam Day?

Can you state whether a scenario is describing top-down (economy to sector to company) or bottom-up (company first) analysis?
Do you know the exact inputs for EPS, P/E, book value per share, P/B, dividend payout ratio, and dividend yield, not just their names?
Can you explain why a high P/E can mean either growth expectations or overvaluation, and why P/E only makes sense compared within the same industry?
Can you subtract preferred stock before dividing by common shares outstanding when computing book value per share?
Can you distinguish dividend yield (income versus price) from payout ratio (income versus earnings), and recognize a yield trap?