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Fundamental Analysis

We're following up on last week's article of Technical Analysis with an overview of Fundamental Analysis. To reiterate, these are the two generally accepted types of securities analysis. They both provide a calculated, educated, prediction of stocks' behavior.

While technical analysis uses past data to predict stock price, fundamental analysis provides a much more intellectual analysis using information such as sales, profits, and ratios. So basically, any time you've considered a stock and asked yourself, "What's the P/E ratio on this stock?", you have used fundamental analysis. The key to fundamental analysis is that investors are evaluating the company and its performance.

Listed below are some basic tools of fundamental analysis, what they are, and how they're used. Please understand that we don't recommend or endorse any "system," and that this article is only basic information to help you understand securities analysis better.

P/E Ratio: (Price per share/Earnings per share) This tells you how expensive a stock is relative to its earnings. Generally, a high profile company that investors really like will have a P/E ratio greater than a low profile company that investors don't like so much.

Example: Microsoft (MSFT) has a P/E Ratio of 66, while Sunoco Petroleum (SUN) has a P/E Ratio of 12. A lot of people like Microsoft and they see great potential for growth, but Sunoco isn't as "high growth" as Microsoft. The P/E Ratio is used to show that relative to earnings, Microsoft is priced much higher than Sunoco.

P/S Ratio: (Price per share/Sales per share) Very similar to the P/E Ratio, the P/S Ratio shows how expensive a stock is relative to its sales or revenues. The P/S Ratio is often used for unprofitable companies in place of the P/E Ratio.

Example: Amazon.com (AMZN) has a P/S Ratio of 21, while Yahoo (YHOO) has a P/S of 128. This shows that relative to sales, Yahoo is valued 6 times greater than Amazon.

Key Points: P/S Ratios are used to compare the price of one company to another. The P/S is often used in place of the P/E ratio for unprofitable companies.

Top Down Approach: The top down approach consists of analyzing securities from "the top downwards." This means evaluating in the following order:

  1. The entire market (is the market headed up or down?)
  2. The Sector (is the sector hot or cold?)
  3. The Industry (is this particular industry hot or cold?)
  4. The specific stock (evaluate the specific stock fundamentally if it passes the first 3)

Example:
  1. You do a study and decide that the stock market will continue to go up.
  2. You evaluate the Technology sector and determine that it's hot
  3. You evaluate the Internet industry and determine that it's hot
  4. You evaluate Yahoo and analyze it fundamentally, and decide whether the stock will go up or down.

Bottom Up Approach: Just the opposite of the Top Down approach. You start from the bottom and analyze upwards.

Example:

  1. Evaluate Yahoo and analyze it fundamentally
  2. Evaluate the Internet industry and determine whether it's hot or cold
  3. Evaluate the Technology sector and determine whether it's hot or cold
  4. Evaluate the overall stock market and predict whether it will go up or down

Cash/Working Captial: This seems very simple, but cash and working capital are very important to all businesses. Cash is needed for growth, paying salaries, paying overhead, and so on. Without cash, even profitable companies can't stay in business.

Example: Microsoft (MSFT) has almost $22 billion in cash. This cash will allow them to grow through new products, research and development, acquisitions, and so on. It will also help them pay the salaries of their 27,000 employees should they ever have a bad year.

To read last week's article on Technical Analysis, please click here.

*Please understand that we don't recommend or endorse any "system," and that this article is only basic information to help you understand securities analysis better.



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