Fundamental Analysis
Fundamental Analysis: Reading a Company's Financial Health
Fundamental analysis determines a company's intrinsic value using financial statements, earnings, and valuation ratios — the foundation of long-term stock investing and catalyst-based trading.
Key rules
- Revenue growth is the #1 indicator of business health — everything else derives from it
- Free Cash Flow (FCF) is the most reliable measure of real earnings — track it, not just net income
- P/E ratio only has meaning within the same sector — a 'high' P/E for a utility is normal for a growth tech stock
- Debt-to-equity above 2 is a warning sign — high debt companies are vulnerable in rising rate environments
- Combine fundamentals (WHAT to buy) with technical analysis (WHEN to buy) for the most complete trading approach
Fundamental analysis evaluates a company's financial health and business quality to determine whether its stock price reflects fair value. Technical traders often dismiss it, but understanding fundamentals is essential for avoiding value traps and identifying catalysts.
**The Three Financial Statements**
**Income Statement**: Revenue → Gross Profit → Operating Income → Net Income. Key metrics: revenue growth rate, gross margin (revenue - COGS / revenue), operating margin, net margin. A company growing revenue while expanding margins is a powerful combination.
**Balance Sheet**: Assets = Liabilities + Shareholders' Equity. Key ratios: Debt-to-Equity (how leveraged is the company), Current Ratio (current assets / current liabilities — above 1.5 is generally healthy), Cash and equivalents (how much runway?).
**Cash Flow Statement**: Often the most honest statement. Net Income can be manipulated; cash flow is harder to fake. Free Cash Flow (FCF = Operating Cash Flow - Capital Expenditures) represents cash the company actually generates after maintaining its operations.
**Key Valuation Ratios**
**P/E Ratio (Price-to-Earnings)**: Stock price / earnings per share. A P/E of 20 means you're paying $20 for every $1 of annual earnings. Compare within sectors — a P/E of 30 is high for a utility but low for a growth tech company.
**PEG Ratio (Price/Earnings/Growth)**: P/E divided by earnings growth rate. A PEG below 1 suggests the stock may be undervalued relative to growth. PEG of 1 = fairly priced for growth; above 1.5 = potentially expensive.
**EV/EBITDA**: Enterprise Value to EBITDA — useful for comparing companies with different capital structures.
**Price-to-Sales (P/S)**: For pre-profit growth companies. A P/S of 10 means you're paying $10 for every $1 of revenue.
**Using Fundamentals with Technical Analysis** The most powerful approach: use fundamentals to select WHAT to trade (strong earnings growth, expanding margins, sector tailwinds) and technical analysis to determine WHEN to trade (entry at a support level, breakout of a base).