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.

Core Approach

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

Key Financial Statement Inputs

  • 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

Core Valuation Metrics

Earnings Per Share (EPS)

EPS=Net IncomeShares Outstanding\text{EPS} = \frac{\text{Net Income}}{\text{Shares Outstanding}}
  • Measures profitability on a per-share basis

Price-to-Earnings (P/E) Ratio

P/E Ratio=Market Price per ShareEPS\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/ELower P/E
Investors expect high future growth (growth stock)Investors expect low growth (value stock)
May indicate overvaluationMay indicate undervaluation
  • P/E is relative - must compare within the same industry or sector

Book Value Per Share

Book Value per Share=Total Assets−Total LiabilitiesShares Outstanding\text{Book Value per Share} = \frac{\text{Total Assets} - \text{Total Liabilities}}{\text{Shares Outstanding}}
  • Represents net asset value attributable to each share
  • Found on the balance sheet

Price-to-Book (P/B) Ratio

P/B Ratio=Market Price per ShareBook Value per Share\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 net assets. You could theoretically buy the whole company and sell its parts for a profit.

Dividend Payout Ratio

Dividend Payout Ratio=Dividends per ShareEPS\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

Exam Tip: Gotchas

  • 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 and P/B ratios are fundamental analysis tools, never technical.