What Is Fundamental Analysis?

Fundamental analysis (in stock market terms) is basically the analysis of a company's financial accounts and financial data to determine whether or not a company is worth investing in.

For example if you study the financial accounts and see that a company has little or no debts, has a high dividend cover figure, is growing it's earnings and dividends year on year, and is basically financially sound, then you may well decide to add this company to your watchlist for further consideration.

Of course just because a company is financially sound does not mean it would make a great investment. For this you should try and value the company in some way to decide whether it's current share price makes it cheap or expensive. There are two ways you can find this information out.

The first is simply to look at the market capitalization (number of shares issued multiplied by current share price) and compare this figure to it's most recent pre-tax profits. If the market capitalization is less than 10 times pre-tax profits, for instance, then this indicates that it is currently quite cheap because if a company were to take it over at the current share price it would take less than 10 years to get their money back. If, however, it's greater than 20 then it's probably overvalued at the moment and you should wait for a better entry point.

The second method is to use the classic price/earnings ratio, or PE ratio as it's more commonly known. This works in a similar way in that you divide the current share price by the earnings per share. If it is trading on a low multiple it is considered cheap and vice versa. It's hard to use this figure on it's own as different sectors have different PE benchmarks so it's best used when compared with other companies in the same sector. You should also look at predicted PE ratios for the next few years as well if this information is provided as this will offer a good estimation of a company's future prospects.

On the whole fundamental analysis should be something that every investor should employ before investing in a particular company. Technical analysis is all well and good but it's completely useless if you end up investing in a poor-performing company or worse still, one that eventually goes bust. So even if you use technical analysis extensively, you should still always do your homework and look at the fundamentals of a company before parting with your hard-earned cash.