Analyze & Select Stocks Through Fundamental Analysis
Investing is a decision about buying a stream of future earnings. Financial statements tell you whether that stream is strong, weak, or declining. This framework shows exactly how to evaluate a company using its financials, and how each insight converts into an investment decision.
“It’s far better to buy a wonderful company at a fair price, than a fair company at a wonderful price.”
Fundamental analysis works because the market values a company based on what it will earn tomorrow, not what it earned yesterday. Financial statements tell you how the company has performed, but the price reacts to where the company is going.
If future earnings expectations rise → the stock tends to go up.
If expectations fall → the stock tends to go down.
This is why you can see a stock drop even after a company reports strong current earnings — if the market expects more, future expectations actually decline, and the price adjusts down.
1. Statement of Financial Position
Assess stability, liquidity, and capital structure.
This statement shows what the company owns, what it owes, and what equity remains for shareholders.
A. Liquidity Analysis
Purpose: Can the company cover near-term obligations without stress?
Key Ratios
Current Ratio = Current Assets / Current Liabilities
Quick Ratio = (Current Assets – Inventory) / Current Liabilities
Interpretation
A ratio near 1.5–2.0 is typically healthy.
Ratios below 1.0 indicate potential short-term cash strain.
Extremely high ratios may signal underutilized assets or weak sales turnover.
What This Means When Picking Stocks
A business with poor liquidity may be forced to raise cash, cut investment, or dilute shareholders during downturns.
Be cautious with companies with <1.0 liquidity unless they demonstrate high inventory turnover or predictable cash inflows.
B. Debt & Capital Structure
Purpose: Evaluate risk and financial flexibility.
Key Ratios
Debt-to-Equity = Total Debt / Equity
Interest Coverage = EBIT / Interest Expense
Interpretation
High leverage increases bankruptcy risk and reduces strategic flexibility.
Strong companies maintain steady or rising interest coverage over years.
What This Means When Picking Stocks
If a company’s debt load is high and earnings are volatile, the investment becomes asymmetric: limited upside, significant downside.
Favour companies with manageable leverage and consistent interest coverage >3×.
C. Equity Base & Retained Earnings
Purpose: See if the company is building long-term value.
Interpretation
Growing retained earnings = reinvested profits fuelling future growth.
Declining retained earnings or constant dilution = value leakage.
What This Means When Picking Stocks
A durable compounder expands its equity base without constant capital raises.
Prioritize businesses with multi-year retained earnings growth and minimal dilution.
2. Statement of Comprehensive Income
Assess profitability, efficiency, and earnings quality.
A. Revenue & Gross Profit
Purpose: Identify whether the core business is economically sound.
Key Metric
Gross Margin = (Revenue – Cost of Sales) / Revenue
Interpretation
Consistently strong margins signal pricing power and a defensible model.
Compressing margins indicate rising costs, competitive pressure, or product weakness.
What This Means When Picking Stocks
A company with declining gross margins is losing its competitive position.
Favour companies with stable or expanding margins over multiple periods.
B. Operating Efficiency
Purpose: Evaluate management’s discipline in controlling costs.
Key Metrics
Net Profit Margin = Profit / Revenue
ROE = Profit / Shareholders’ Equity
Interpretation
High net margins reflect operational strength.
High ROE (>15%) suggests efficient capital allocation — unless driven by excessive debt.
What This Means When Picking Stocks
Operational excellence compounds over time.
Avoid companies dependent on leverage to inflate ROE. Focus on businesses with organically strong ROE.
C. Earnings Quality
Purpose: Determine if profits are real and repeatable.
Red Flags
High profits but weak operating cash flow.
Erratic earnings with no structural explanation.
One-time gains inflating net income.
What This Means When Picking Stocks
Low-quality earnings lead to overvaluation and eventual re-pricing.
Select companies where earnings growth is backed by cash flow growth.
3. Statement of Changes in Equity
Track how profit is allocated.
Key Insights
Profits increase retained earnings; dividends decrease them.
Strategic capital allocation shows up here.
What You’re Looking For
Consistent retained earnings growth
Reasonable dividend policy (not draining capital)
No chronic share dilution
What This Means When Picking Stocks
Capital allocation quality determines long-term returns.
Prefer management teams that reinvest profits effectively instead of masking weak performance with dividends.
4. Ratio Analysis: Turning Data Into Insight
These ratios convert financial statements into decision-grade information.
A. Liquidity Ratios
Shows short-term financial resilience.
Stock Picking Implication:
Avoid companies that must refinance constantly to survive.
B. Risk Ratios
Measures leverage and default risk.
Stock Picking Implication:
Be cautious in businesses where interest coverage is declining across multiple periods.
C. Operating Performance Ratios
Indicates profitability and managerial efficiency.
Stock Picking Implication:
Strong operating ratios show competitive stability — a core attribute of long-term winners.
D. Value Ratios
Shows how the market is pricing the company.
Key Metrics
EPS — how much profit belongs to each share
Dividend Yield — return through income
P/E Ratio — price relative to earnings
Interpretation
High P/E = market expects growth
Low P/E = potential undervaluation or underlying issues
Rising EPS = positive signal for long-term appreciation
What This Means When Picking Stocks
Valuation is context-dependent.
Buy high-quality companies at reasonable P/E multiples relative to peers and growth prospects.
5. Trend Analysis
Single-year data is noise. Five-year data is insight.
Look for sustained patterns in:
Revenue
Margins
Cash flow
ROE
Debt levels
What This Means When Picking Stocks
The best investments show multi-year improvements, not one-year spikes.
Be cautious on companies with declining multi-year trends, even if the latest quarter looks strong.
6. External Comparison
Context defines reality.
Compare a company to:
Direct competitors
Industry averages
Historical norms
What This Means When Picking Stocks
Being “good” relative to itself is meaningless if the industry is deteriorating.
Choose businesses outperforming their sector — not just improving internally.
Fundamentals determine durability. Durability determines compounding. Compounding determines long-term returns. Use them to eliminate fragile businesses and identify companies with structural strength, efficient operations, and robust future earnings potential.
