Why Fundamental Analysis Matters


This site heavily focuses on technical analysis, but through experience, I learned that a company's fundamentals need to be understood to access risk properly. The stronger the company is fundamentally the less risk there is when holding. Keep in mind the best trader out there: Warren Buffet, is famous for value investing, so it's always good to have a solid understanding of this strategy, even if you won't be using it much going forward.


This article will cover five fundamental financial metrics that you should understand before trading and investing in a stock. As, fundamentals do matter (unless day trading), even if your trading strategy heavily focuses on Technical Analysis. I really can't emphasize this enough, you really need to understand what you are investing in. Investing in the hype with no fundamentals to back the stock up will humble you in the Market. 


Always be asking, do the fundamentals support the hype? What happens in the next few months/years if the company enters a rough patch? Do they have enough cash, or will they have to go bankrupt, thus wiping their stock to $0? These are the questions you need to have answered. For example, trading small-cap oil stocks, the fundamentals are never there. What sharp drop in Oil Prices usually sends these companies into bankruptcy. 


Fundamental Analysis


For analyzing the fundamentals of a stock, let's use Tesla ($TSLA) as an example. Tesla has been making all the right noises lately and just continues to defy everyone's expectations as it powers to never-ending all-time highs. Many people think the stock is overvalued, but what is the basis for this claim? Hopefully, the basic metrics covered will give you a starting point to answering if Tesla's market cap is justified.

The following are five value investing metrics. They are easily found when looking up stock quotes in your favorite broker or app, as well as covered in quarterly reports by every public traded company.


Earnings Growth: Tesla's year-on-year revenue improvement reported for the third quarter is 39.16%, marginally lower than its recent surge of a staggering 193%. However, Tesla Inc. stands 2nd in the Auto & Truck Manufacturers Industry when it comes to revenue growth.  Always remember that the fluctuation in revenue growth for a stock doesn't need to be huge, but should be consistent.


Plowback Ratio and Reserves: Dividends and plowback are a part of the company's net profit. These are obtained after deducing all expenses of a company including all applicable taxes. A dividend is what the company gives to its shareholders. Plowback is that part of the company's net profit which the company adds to its existing reserves that are further used for the growth/expansion of the company. Strong reserves indicate strong fundamentals and growth.




Debt-to-Equity Ratio: The latest report for Tesla Inc. indicates this ratio at 1.80. It is obtained by dividing the total debt of the company by shareholder's equity. The biggest of companies have liabilities and debts in their balance sheets. Ideally, companies with lower debt to equity ratios are considered to be the best bet, but it depends on the magnitude of the industry too.


Price-to-Earnings Ratio: The trailing-twelve-month P/E of Tesla stands at 129.12X. This is not at par with the Automotive - Domestic Industry's P/E which stands at 15.71X. P/E ratio is one of the major indicators of how a stock is performing and how much a shareholder is earning. For example, if a stock has a P/E ratio of 25, it indicates that the stock is trading at 25 times its TTE (trailing twelve month's earnings). The lower the number, the better it is considered to be. In my opinion, the P/E ratio is outdated and really doesn't apply to the most popular growth stocks today.


Dividend: Tesla doesn't pay a dividend to its shareholders. However, the share price of the stock has returned over 850% within the last few years, despite being negative in 2021. If a company pays dividends consistently, it shows that it is stable and deep-rooted. A higher dividend may often be an indicator of instability with the company. Also, it shows that the company has no plan of extension and the growth will be very slow. So you may get worse returns with stocks that pay "good" dividends (basically those that pay higher than a savings rate).



Bonus Tip: Never trust reports that come out of China or any other company outside of the United States, as the majority of the time the accounting and reporting are greatly exaggerated to the point it is often fraud!


Conclusion 


Hopefully, this article gives you a nudge into thinking about fundamentals, even if you are purely a technical trader. You always need to think outside the box and consider every edge you can get, and also protect yourself from the worst-case scenario when you decide to hold a stock overnight. Because worst-case scenarios unfortunately happen way more than you think!


For more into understanding Fundamental Analysis, I suggest checking out Fundamental analysis: a beginner’s guide.


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