Table Of Content
Fundamental analysis helps you dig into a company’s financial health, performance, and future potential to figure out if it’s a smart investment.
It’s what long-term investors use to separate solid businesses from risky plays. This article will walk you through how it works and the key financial ratios that matter most.
What Is Fundamental Analysis and How Does It Work?
Fundamental analysis is a method of evaluating a company’s value by examining its financial statements, business model, industry position, and future growth prospects.
The goal is to determine whether a stock is trading above or below its “intrinsic value”—what the company is worth based on fundamentals.
Investors use this analysis to make more informed decisions, especially when considering long-term plans. Instead of focusing only on stock price movements (like technical traders do), fundamental analysts examine factors such as revenue growth, profit margins, debt levels, and competitive advantages.
-
Example: When Investors Can Use Fundamental Analysis?
Let’s say a company’s stock is trading at $40, but after analyzing its financials, you believe it's worth $60. That gap presents a potential opportunity.
On the flip side, a company might look flashy on the surface but show warning signs in its balance sheet.
Whether you're evaluating a single stock or comparing companies in the same sector, fundamental analysis helps you focus on what really matters.
Key Financial Ratios Used in Fundamental Analysis
Financial ratios help investors evaluate a company’s performance, value, and stability. Here are the most important ones used in fundamental analysis.
Ratio | Formula | What It Measures | Ideal Range or Signal |
|---|---|---|---|
Price-to-Earnings (P/E) | Share Price ÷ Earnings per Share | Valuation based on earnings | Compare to industry average |
Price-to-Book (P/B) | Share Price ÷ Book Value per Share | Valuation based on assets | Below 1 may indicate undervaluation |
Return on Equity (ROE) | Net Income ÷ Shareholder Equity | Profitability from shareholders' capital | 15% or higher is generally strong |
Debt-to-Equity (D/E) | Total Liabilities ÷ Shareholder Equity | Financial leverage and risk | Lower is typically safer (contextual) |
Current Ratio | Current Assets ÷ Current Liabilities | Short-term financial health | Above 1 is usually healthy |
Earnings Per Share (EPS) | Net Income ÷ Shares Outstanding | Profit per share of stock | Higher over time indicates growth |
1. Price-to-Earnings (P/E) Ratio
The P/E ratio shows how much investors are paying for $1 of a company’s earnings. It's calculated like this:
P/E = Share Price ÷ Earnings Per Share (EPS)
-
Example: How To Use P/E Ratio?
For example, if a stock trades at $50 and its EPS is $5, the P/E is 10.
That means investors are paying 10 times the company’s earnings. A lower P/E could suggest a stock is undervalued—but it might also signal slower growth or risks.
Tech stocks often have higher P/Es because investors expect faster growth, while mature companies like utilities tend to have lower ones.
Always compare a P/E to similar companies or the industry average—it’s not very useful on its own.
2. Price-to-Book (P/B) Ratio
The P/B ratio compares a stock’s market price to its book value (what the company would be worth if it sold everything and paid off its debts). The formula:
P/B = Share Price ÷ Book Value per Share
-
Example: How To Use P/B Ratio?
If a company has a book value of $20/share and trades at $30, its P/B is 1.5. That means you're paying 1.5 times the company’s net assets.
A P/B under 1 can indicate undervaluation—maybe the market’s missing something. But it could also mean the business is struggling.
Value investors often hunt for low P/B ratios, especially in asset-heavy sectors like banks or industrials.
3. Return on Equity (ROE)
ROE measures how effectively a company uses shareholder money to generate profits. The formula is:
ROE = Net Income ÷ Shareholder Equity
-
Example: How To Use to ROE?
If a company earns $1 million in profit on $5 million of equity, its ROE is 20%. That’s considered strong—it means the company is generating $0.20 for every $1 invested by shareholders.
High ROE can be a sign of a high-quality business. Just make sure it’s not inflated by too much debt, since leverage can artificially boost ROE.
4. Debt-to-Equity (D/E) Ratio
The D/E ratio shows how much a company relies on debt versus its own equity to finance operations:
D/E = Total Liabilities ÷ Shareholder Equity
-
Example: How To Use D/E Ratio?
If a company has $10 million in debt and $20 million in equity, its D/E is 0.5. A low D/E means a company is less reliant on borrowing, which often makes it more stable during downturns.
A higher D/E can increase risk, especially in interest-rate sensitive industries. Still, some sectors like utilities and telecom often carry more debt—it’s all about context.
5. Current Ratio
The current ratio measures a company’s ability to pay its short-term obligations:
Current Ratio = Current Assets ÷ Current Liabilities
-
Example: How To Use Current Ratio?
If a company has $4 million in current assets and $2 million in current liabilities, the ratio is 2.0. That means it has twice the assets it needs to cover short-term bills.
A current ratio over 1 is usually healthy, but too high might suggest underused cash or poor capital allocation. If the ratio is under 1, it could signal liquidity issues.
6. Earnings Per Share (EPS)
EPS shows how much profit a company makes for each share of stock:
EPS = Net Income ÷ Shares Outstanding
-
Example: How To Use Current Ratio?
If a company earns $10 million and has 5 million shares, its EPS is $2. A rising EPS over time is a good sign—it means the company is growing profits.
But watch for one-time gains that can inflate earnings. Some investors also use “diluted EPS” to account for stock options or convertible debt that could increase the share count.
How to Use Fundamental Analysis to Pick Winning Stocks
Once you understand the key ratios and financial metrics, the next step is putting them to work.
Fundamental analysis helps you filter out hype and focus on companies with real value and long-term potential.
It’s not about finding “hot” stocks—it’s about identifying strong businesses at fair prices.
Ratio | Stock A | Stock B | Analysis Insight |
|---|---|---|---|
P/E Ratio | 12 | 25 | Stock A may be undervalued or slower growth |
ROE | 18% | 9% | Stock A uses capital more efficiently |
D/E Ratio | 0.4 | 1.2 | Stock A carries less debt (lower risk) |
Current Ratio | 2.1 | 0.9 | Stock B may have liquidity concerns |
EPS | $3.50 | $1.80 | Stock A is more profitable per share |
Here’s how to use fundamental analysis effectively when picking stocks:
Start with what you understand: Focus on industries or businesses you can easily grasp. If you don’t know how a company makes money, it’s hard to assess its fundamentals.
Look for consistent earnings growth: Review the company’s income statement. Is revenue and net income growing steadily over the last 5–10 years?
Check key ratios in context: Compare metrics like P/E, ROE, and D/E to industry averages. A “low” P/E isn’t always a good deal—sometimes it means declining prospects.
Evaluate the company's financial health: Ensure it has sufficient liquidity (a high current ratio) and manageable debt levels. A strong balance sheet means it can survive downturns.
Understand the competitive edge: Does the company have a “moat”—like brand power, patents, or network effects—that protects it from rivals?
Read the annual report or 10-K: This gives insight into management’s strategy, risks, and long-term goals.
Fundamental analysis is about seeing the bigger picture. You’re not just buying stocks—you’re buying a piece of a business.
Fundemental analysis tools such as screeners to filter out stocks based on fundamental data:
Fundamental vs Technical Analysis: How to Combine Them?
Fundamental and technical analysis don’t have to be enemies. In fact, many smart investors use both to make better decisions.
Think of fundamental analysis as helping you decide what to buy, and technical analysis as helping you decide when to buy or sell. Here’s how to combine them effectively:
Start with fundamentals: Use earnings, growth, and valuation metrics to find high-quality companies worth owning long-term.
Use technicals for timing: Look at price trends, moving averages, or support/resistance levels to identify smart entry or exit points.
Avoid value traps: A stock might look cheap fundamentally, but a falling price trend can be a warning sign. Technicals can help confirm if momentum is shifting.
Confirm breakouts with fundamentals: If a stock breaks out of a key resistance level, strong earnings or guidance can add confidence to the move.
Think in layers: Use fundamentals for the core thesis, and technicals as a final layer before you pull the trigger.
Together, these tools can give you a more complete picture—so you're not just guessing based on charts or headlines.
FAQ
Ideally, you should review your analysis quarterly or when the company releases key financial updates.
It's primarily used for long-term investing since it evaluates a company’s intrinsic value and growth potential over time.
Yes, though it's more complex—you’d analyze the underlying holdings and sector exposures of the fund.
Absolutely. Factors like interest rates, inflation, and GDP growth can impact company performance and investor sentiment.
Strong and consistent dividends can signal financial health and shareholder-friendly policies, especially for income investors.
Yes—platforms like Morningstar, Seeking Alpha, and Yahoo Finance offer ratio data, earnings history, and analyst reports.
You can, but it’s harder due to the lack of public financial disclosures. Most analysis is done on public companies.
It may overlook short-term price trends or sentiment-driven moves, which can affect timing and volatility.
Rising inflation can raise costs, squeeze margins, and reduce consumer spending—hurting earnings and profitability.
Not always—startups and growth stocks might operate at a loss initially but still show strong future potential.
