Step 3: Fundamental analysis
Investors use two broad types of analysis when considering whether a stock is likely to go up or down: fundamental analysis and technical analysis.
Fundamental analysis involves looking at the overall economy, the sector in which a business operates, as well as a particular company's financial statements – which yield the information to calculate measures or 'ratios' such as earnings per share, the price-earnings ratio and dividend yield.
Investors typically use two main fundamental approaches: a top-down approach or a bottom-up approach.
The top-down approach is a form of analysis that drills down from the state of the market or economy to a particular industry, and then to the selection of individual companies for investment.
The bottom-up approach, on the other hand, begins by analysing a company's fundamentals before proceeding to look at the economy as a whole.
In top-down investing, investors seek to derive returns mainly from general market factors. They profit from holding a portfolio and following the trend. In bottom-up investing, investors seek to profit mainly from stock-specific factors.
Either way, investors using fundamental analysis will look at key company measures such as gross and net profit, earnings per share, dividend payout, the price-earnings (P/E) ratio, the debt-equity ratio and the company's coverage of interest payments.
In considering the impact of the wider economy, they'll keep an eye on economic growth, the direction of interest rates, the trend in corporate profits generally, benchmark indices such as the S&P/ASX200 and the market's own P/E ratio, among other things.
The overarching principle of fundamental analysis is that an investor must focus on the company itself, rather than movements in its stock price.
Fundamental analysis looks at company measures such as:
- gross and net profit
- earnings per share
- dividend payout
- price-earnings (P/E) ratio
- debt-to-equity ratio
- interest cover
and overall measures such as:
- economic growth
- interest rates
- corporate profitability