Investing Basics: Fundamental Analysis

Fundamental analysis
is the process of examining a company's
financial statements to help decide if its
stock is a good investment. Financial statements
include balance sheets, income statements, and
cash flow statements. This information helps
determine the financial makeup of the company behind the stock. In this video, we'll explain
how fundamental analysis uses these statements to
help evaluate a company. Let's start with
a balance sheet. This document compares the
company's current assets to its liabilities
and owner's equity. Let's define these terms. First, we have assets, which
are items the company owns. Assets are usually comprised of
cash, equipment, and property. Next are liabilities. Liabilities are usually debts or
accounts that need to be paid. Often, a liability
on the balance sheet has an offsetting asset that
helps the numbers stay level.

For example, if a company
were to take a loan out to buy a property, the
loan would be a liability, and the property
would be an asset. The third term of
a balance sheet is capital or
owner's equity, which is the amount of assets
raised by issuing stock. For example, when a
company issues stock either in its initial
public offering or in a secondary offering,
it raises money or capital that can be used to fund
various business expenses. Balance is achieved when
the value of the assets are equal to liabilities
and owner's equity. The balance sheet helps you
see how a company raises money for its assets and
can help you determine if the company is overextended. However, if you want to know
how the company earns money, you'd look at its
income statement. An income statement shows
a company's revenues and expenses. These are the costs
associated with running the business, including
operations, interest paid on loans, and taxes. When you take revenues
and subtract expenses, you get net income. Net income is the
earnings of a company. Earnings are usually
handled in two ways. The first way is to share the
earnings with shareholders by paying a dividend.

The second way is to
reinvest these earnings into the company. Reinvesting earnings can help
a company's cash position. A company with a
good cash position is usually better prepared to
endure economic ups and downs. This is why some investors
say cash is king. It's also why the cash flow
statement is an important item to consider. This statement shows
how the company uses its cash to operate the
business and make investments.

It also shows how
much is borrowed from a bank or a bondholder. These figures are totaled to
show changes in the company's overall cash position. This statement is
important because it gives a more detailed account
of how the business generates revenue, and is therefore much
more difficult to manipulate than an income statement. As you can see, there is a lot
of information in the three financial statements. With all of these
facts and figures, analysis can be a little tricky. This is why some
investors may use ratios. There are several ratios that
can help an investor compare stocks, but we'll focus on one
of the most common, the price to earnings or P/E ratio. Let's say you have one stock
that's trading at a $6 share, another at $35 a share, and
a third at $132 a share.

How would you know which
one is the best value? Some might assume the $6 stock
is the best value, because it's the cheapest. However, this might
not be the case, because a company's
value may depend largely on the company's earnings. The P/E ratio allows you to
look beyond the price of a stock to see which company
could be the best value. To create this ratio,
first divide the net income or earnings by the number
of outstanding shares. This number is called
Earnings Per Share or EPS. Next, divide the
price of the stock by the EPS to get the P/E ratio. The first company is trading
at $6 and has an EPS of $0.20, resulting in a P/E of 30. The second company is trading
at $35 a share and has an EPA of $1.40 for a P/E of 25. The final company is trading at
$132 per share and has an EPA of $3.90 for a P/E of 34. Now, you can better compare
each company by its P/E ratio. Despite the drastic
difference in stock prices, all three companies have
a similar valuation. However, the second company
has the lowest P/E ratio and may be the best value.

Remember, a P/E ratio is
only one of several ratios that can be used. There are other
ratios for determining valuation, profitability,
and financial strength. There are also other
figures to examine in financial statements. We've only scratched the
surface of fundamental analysis in this video. It's important that you learn
more before using this analysis to make a trade, and
we're here to help you every step along the way. [MUSIC PLAYING] .

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