How to Identify Fundamentally Strong Stocks
|Below content does not provide investment advice.|
The secret to winning in the stock market is consistent returns over time. But not all listed companies generate such returns while maintaining less volatility. You must do proper research and analysis to find fundamentally strong stocks.
What is Fundamental Analysis
Essentially, fundamental analysis involves evaluating the stock's intrinsic value and comparing it with the current price to determine the company's financial health. This consists of checking the quantitative and qualitative economic and financial factors.
Fundamentals are contrasted with technical analysis, which involves analysis of the charts and can be limited to short-term projections. As McCall report suggests, fundamental analysis looks at the long-term picture by looking at the cash flow statement, income statement, and balance sheet.
Now, how do you identify such stocks?
Fundamental Analysis Process
Here is a short guide for the fundamental analysis of stocks.
1. Understanding the Company
Visit the company’s website and learn about its management, goals, products, and promoters. Analyze whether its decisions align with future goals and determine whether you should hold or sell the stocks based on their performance.
2. Examine Financial Reports
The next step is analyzing financial reports such as cash flow, revenues., balance sheet, and profit and loss. A company with a good compounded annual growth rate (CARG) is a suitable investment.
3. Examine the Debt
Essentially you should avoid companies with huge debt. Investing in companies with less than a 1:1 debt-equity ratio is less risky. A company with huge debt can’t perform optimally or offer you good returns.
4. Analyze prospects and company competitors and constantly review all aspects.
Vital Financial Statements
A company's financial statements, including the balance sheet, cash flow, and income statement, give you a sneak peek of the performance currently and in the past. Has the company paid handsome dividends recently? If the company is growing consistently, that is a tell-tale sign that its prospects are good.
Financial ratios help you analyze the financial statement and determine the performance of the company. Below are essential ratios you should consider.
Operating cost ratios determine the management's effectiveness in reducing operational costs. Essentially, it shows how the business manages costs. There are various operating ratios.
The Working Capital Turnover
The working capital turnover ratio measures the effectiveness of the business in leveraging working capital to generate higher working capital. A high ratio means the company's management has devised effective ways of using relatively low capital to generate higher sales. Working capital turnover = net sales/average working capital
Total Assets Turnover
A high total assets turnover value indicates that the company effectively uses its assets to generate high revenue. Total asset turnover = net sales /total assets
Inventory Turnover Ratio
As the name impulses, the ratio is an excellent measure of how the company can convert inventory into sales. How well is the management controlling and selling, and replacing the inventory? Inventory turnover ratio = cost of goods sold /average inventory
These ratios are quite popular among investors and analysts. They give a clear picture of a company's investment potential and how the share price is fairing in relation to its finances. The two common valuation ratios are:
Price to Earnings Ratio
A low P/E indicates the share is undervalued hand hence providing a great investment opportunity. P/E = current market price /earning per share
Price to Book Value (P/B)
The ratio compares the market value of a company's share and its book value. A higher value indicates an overvalued stock; you should probably stay out. P/B = Current market price /book value paper share
A company with higher profitability can generate more income than expenses. Ideally, you will want to invest in a company with a higher profitability ratio. During your analysis, you should check at least the following two ratios.
Net Profit Margin
This ratio measures the company’s ability to generate revenue from sales. You should therefore choose a company with a high net profit margin. Net profit margin = net profit /revenue
Earnings before interest, taxes, depreciation and amortization (EBITDA) measure a company's operating income. Ensure you compare this income with the company's revenue and its margin with other companies to determine its performance. EBITDA margin =EBITDA/revenue
Next, you will want to examine the leverage ratios, which measure whether the company can meet its financial obligation and how it is financed. You should be concerned if the company is highly leveraged and can't generate revenue.
Debt to Equity Ratio
This is self-explanatory. It shows the company's debt position. Essentially, you want to invest in a company with a low debt to equity ratio, typically less than one. A ratio that is more than two is highly risky. Debt to equity ratio = total debt /total equity
Interest Coverage Ratio
This measures the company's ability to settle its debt. Again, a suitable company for stock investment should be in a position to pay off its debts easily. Interest coverage ratio = earnings before interest and tax( EBIT) /interest expense
A fundamentally strong company is less reliant on debt. It can run its daily operations using share capital and reserves. Essentially its employed capital should not be more than the total expense. Low debt means the net profits will also be high because companies pay off debt from gross profit. But debt is not always bad; it comes in handy in providing liquidity for immediate working capital.
Solid Cash flow
Cash flow also points to the fundamental strength of a company. If the company relies on share capital and reserves, it signifies that it is dependent on debt and is collecting cash fast enough. Fast cash flow points to financial independence, which is beneficial because it generates liquidity, takes care of liability, eliminates debts, and ensures liabilities are paid in time.
In addition, the company must also grow its reserves with time. If a company has employed more total expenses than the capital, the reserve will show negative growth, which points to bad fundamentals.
Once you ensure the ratios are positive, you must also check the company's practices. A company that is not based on ethics would withstand for long. Essentially you want to ensure the company strikes a good balance between economic, social, individual, and community goals.
Take is an example of a bank lending high rates to people with low repayment capacity. The predatory loans won't withstand, and the non-performing asset might break limits. And in no time, it will close business.
Business future Prospects
At that point, you have a clear picture of the business's past performance and current standing. Now it is time to look into the future. A company with a promising future to generate better returns will appeal to investors. What are the future expansion plans of the company?
In addition, the company model should be receptive to new technology to avoid becoming obsolete. Evaluate the industry trends and determine how fast companies can evolve and generate revenue. For instance, a suitable company should have plans to adopt artificial intelligence. A keen look at the company's future plans and industry outlook will help you choose a company worth investing in. In general, a good suitable company should have good fundamentals.
Moreover, examine macro factors such as inflation and GDP. Stocks price increases in tandem with GDP but have an inverse correlation with inflations.
Monopolies tend to excel because they have a competitive edge. Ensure the company can sustain its market over time and its goodwill, patents, and brand name give it a competitive advantage.
Choose a Financially Independent Company
Fundamentally strong companies are for those who can withstand tough times and financial storms. Identifying strong stocks involves time-to-time analysis. You might want to choose blue-chip companies because they have competitive advantages and their business models are adaptable to changes. However, small cap companies can also have strong fundamentals. Ensure you consider all the parameters.