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How fundamental analysis is effective in evaluating a stock?

Team Veye | 01 Nov 2021

How fundamental analysis is effective in evaluating a stock?

The aim of the fundamental analysis is to use it as a way to better understand business and investment. It is best known as a tool for investors trying to get a very detailed assessment of what a company is worth.

Fundamental analyses attempt to identify stocks offering strong growth potential at a good price by examining the underlying company’s business, as well as conditions within its industry or in the broader economy. Ideally, it would begin by assessing the value of the Company’s assets, income streams, debts, and liabilities.

Fundamental analysis also considers how external and internal factors affect the price of a company’s securities. External factors are like GDP and GNP as measures of the economy, the business cycle, reasons for economic growth; interest rates; inflation; the labour market; foreign trade and government fiscal and monetary policies.

Internal factors that are taken into account in such analysis are prospects for growth; competition; return on equity; factors affecting profitability; and financial statements.

Investors have traditionally also used fundamental analysis for longer-term trades, relying on metrics as outlined below.

Free Cash Flow (FCF) is the cash produced by a company through its operations, minus the cost of expenditures. In other words, free cash flow is the cash left over after a company pays for its operating expenses and capital expenditures. It shows the efficiency of the company in generating cash

Enterprise value is an economic measure reflecting the market value of a business. It is a measure of the total value of a company that shows how much it would cost to buy the entire company, including its debt.

The dividend Payout Ratio gives two important pieces of information, one is how much dividend is paid to the shareholders out of the profit of the company. The second is retained earnings of the company.

The price Sales Ratio is used to recognize the price of the stock as compared to the revenue. It helps understand the growth of the share price against the revenue generated in that year.

While technical analysis concentrates on forecasting a security’s price movements, the fundamental analysis aims to determine the “correct price” or true value of a security. By knowing the right price, an investor can make an informed investment decision.

Disclaimer

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