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Fundamental analysis is the process of assessing a company’s value by evaluating data from its financial statements and comparing it to that of its peers.

It sounds like a lot of extra work, which is why many swing traders ignore fundamental analysis.

While it is true that you can still make a profit relying solely on technical analysis, digging into the fundamentals of a company, even just a little bit, will help you pick those winning trades more often.

Typically, a company will release its earnings every three months. You can easily find prior earnings release dates for any company on the internet.

The important thing to remember about earnings reports is that they often create major movements in a stock's price. Unfortunately, which way it will move is unpredictable.

Never hold a stock during the company’s release of its earnings report.

A good general rule is to not enter any position if a company plans to release its earnings within two weeks, and to wait a few days after the earnings report to let things settle a bit.

When assessing a company’s financial statements, the main question to ask is whether or not the company over- or under-performed in comparison to expectations.

The larger the percentage beat, in both sales and earnings, the better.

A company’s balance sheet is like a snapshot of its overall health.

It will tell you the value of a company’s assets, liabilities, and shareholders’ equity.

An asset is something that will provide future benefit. Cash, inventory, equipment, etc. Current assets are expected to convert into cash within the next 12 months. Anything over 12 months is considered a long-term asset.

Liabilities are what the company owes others. Current liabilities are expenses that are to be paid within the next 12 months, such as operating expenses, salaries, and short-term debt. Long-term liabilities are expenses that aren’t due for over 12 months.

Shareholders’ equity is the difference between total assets and total liabilities.

The total value of assets must equal the total value of liabilities and shareholders’ equity. Presented as a formula:

Assets = Liabilities + Shareholders’ equity.

To properly assess a balance sheet, keep the following guidelines in mind:

• The more cash a company has relative to its debts, the better.
• Compare current assets to current liabilities. A ratio of at least 1.5 is preferable. A ratio of below 1 can signal future problems.
• Compare long-term debt to shareholders’ equity. You want it to be below 30%.
• Large increases in accounts receivable can mean that a company is extending loose credit terms to increase sales, which is bad.
• Large increases in inventory is bad.

A company’s income statement shows its profit and losses over a period of time.

Revenues, sales, and turnover all mean the same thing. Whatever it is called on the statement, it is the lifeblood of any business.

Gross profit is how much money is leftover after subtracting all direct costs related to the sale of goods, such as manufacturing costs and hiring sales people. It doesn’t include indirect costs.

Gross profit is often given as a percentage of sales. The higher the ratio, the more profitable the company.

Operating income is the leftover after subtracting all indirect costs (selling, general, and administrative) from the gross profit. Things like marketing, electricity bills, and accountants salaries are good examples of indirect costs.

Net income is the figure you get after subtracting all other expenses, such as taxes and interest on debt payments. This final figure is the bottom line.

Dividing net profit by the number of outstanding shares gives the income per share figure.

To properly assess an income statement sheet, keep the following guidelines in mind:

• Net income rising faster (year over year) than sales is a good sign.
• Look at the trend of gross profit as a percentage of sales. A rising ratio is a good sign.
• Look at the trend of operating income as a percentage of sales. A rising ratio is a good sign.
• Compare quarterly sales and earnings to the same quarter a year ago as opposed to the previous quarter.
• Growth in outstanding shares is a bad sign.

The cash flow statement tells you:

• How much cash was generated
• What it did with that cash
• Whether money was borrowed or paid out

For a swing trader, the most important part of the cash flow statement is cash flow from operating activities. This tells you if the company actually generated cash or not.

Cash flow from operations should rise (or fall) with net income. If not, it signals that a majority of sales are on credit.

Another important part of the cash flow statement is capital expenditures. These are the costs required to buy and maintain physical assets. The smaller the level of capital expenditures relative to sales, the better.

The last thing to look for is the cash flow from financial activities. This shows how a company raises and pays back money through loans, stock sales, and dividends.

To properly assess a cash flow statement, keep the following guidelines in mind:

• Net income rising with cash flows declining is bad.
• Look at capital expenditure relative to sales. The lower the ratio, the better.
• Look how the company is producing cash. If it is borrowing money and/or issuing stock to keep in business, it is a bad sign.
• Assess the cash flow from financing activities. Borrowing lots of money is bad. Paying off lots of debt is good.
• Be wary of acquisitions that are not part of a company’s strategy.

There are other things to look at to find a healthy company besides just the financial reports.

Insider Ownership: When the company’s top management owns shares, it is a good sign since they have skin in the game. Look for insider ownership of at least 10%.

Economic Moat: Companies that have a big competitive advantage will prevent competition from taking market share. This includes things like brand loyalty, cost advantages, and patents.

Positive Catalysts: A catalyst triggers investors to revalue shares. Positive catalysts can include things like successful new products, new management, and positive related news events.

There are two main methods of valuing stocks. Relative and absolute.

Relative valuation is when you estimate a company’s worth by comparing it to its peers. Absolute valuation is when you evaluate a company's value based on its intrinsic factors, such as historical performance and future cash flows.

As a swing trader, it is best to use relative valuation since it is easier and faster. The most common method to do this is by using the price to earnings ratio (P/E ratio).

You need to figure out what multiple your security should trade at in regard to the P/E ratio. Look at the average P/E of the industry and then decide if the company you are examining should be trading at a premium or a discount to its industry.

A company that can grow earnings faster than its industry should have a higher P/E ratio than its peers.

Next, determine how much of a premium or discount it should have by measuring how much higher or lower its margins are in comparison to its industry. Do this by assessing things like profit margins, earnings growth rates, and efficiency ratios.

Fundamental analysis may seem like a lot of extra work and it can be tempting to follow the buy and sell recommendations from ‘expert analysts’.

This is a mistake.

Unfortunately, analysts do not give recommendations based on what is best for you. They give them based on what will make them the most money.

Additionally, they are dishing out the same information to the masses, and when it comes to the market, the majority is often wrong.

Do your own research and you will have more success in the long run.

Read the next chapter here.

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