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Fundamental Analysis

Fundamental Analysis is a method of analyzing securities by studying the economic, industry, and company conditions in an effort to determine the value of a company's stock. The ultimate result is to determine whether a stock is over, under, or correctly valued.

Types of questions fundamental analysts ask are: Where are we in the economic cycle? Are interest rates falling or rising? Is the stock in question in a popular industry, or an industry out of favor?

Further, the Fundamental Analyst will also rip apart the numbers, such as the company's balance sheet and income statement. Popular ratios which are often of particular focus are Profit Margins, book value, debt ratios, cash flow, and inventory turnover.

Profit Margin. Profit margin is a profitability ratio that is calculated by dividing net income by total sales. The result tells you how much profit the company can eek out from each dollar of sales. A profit margin of 25%in dicates that $0.25 of every $1.00 in sales is profit. This is further compared to previous estimates given by the company, historical performance, and with other companies in the same industry.

Book Value Per Share. A company's book value a price ratio calculated by dividing total net assets (assets minus liabilities) by total shares outstanding. The resultant number gives the investor an idea of what the company would be worth on 'liquidation'. For instance, if a security is selling at a price under book, then it could be an indication that the stock is undervalued. Again, an investor would want to look at comparable book values of similar types of companies.

Price/Earnings Ratio. PE ratio is calculated by dividing the security's current stock price by the previous four quarter's earnings per share (EPS). The PE ratio indicates how much and investor is willing to pay for $1 worth of a company's earning For example, if a stock's current price is $30 and the EPS for the last four quarters was $1.50, the P/E ratio is 20 ($30/$1.50 = 20). This means you pay $20 to "buy" $1 of the company's earnings. Forward PEs also are all quite popular now. This tool uses the consensus expectation of earnings as the basis for the calculation.

There has been a lot of discussion on the 'worth' of PEs, particularly during the last bull market cycle. PE ratios at that time were historically high, and there were mainly who maintained that the ratio was worthless. However, many still use PEs to spot opportunies, both short and long. They are normally used to compare stocks within the same industry, as the PEs from industry to industry vary widely.


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