Upbeat music plays throughout˳
Narrator: 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˳
We’ll explain how fundamental analysis uses these statements to help evaluate a company˳
Let’s start with the balance sheet˳ This document compares the company’s current assets to its liabilities and shareholders’ 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 shareholders” equity, also known as “book value”˳ Shareholders’ equity is the amount of money that would be left to shareholders if the company shut down and sold its assets and paid all its liabilities˳ If you subtract a company’s liabilities from its assets, you will have the shareholder’s equity˳
On-screen disclosure: Stock trading involves high risks, and you can experience a significant loss of funds invested˳
Balance is achieved when the value of the assets is equal to liabilities and shareholders’ 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 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 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˳
On-screen disclosure: For illustrative purposes only˳ Not a recommendation of any security or strategy˳
Let’s say you have one stock that’s trading at $6 a 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 EPS of $1˳40 for a P/E of 25˳
The final company is trading at $132 per share and has an EPS 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˳
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