Introduction
Investing in the stock market can be profitable, but choosing the right stocks is crucial for long-term success. When selecting stocks, investors often rely on fundamental analysis—examining financial health, industry positioning, and growth potential. This cheat sheet simplifies the core criteria of fundamental analysis, helping you quickly identify stocks with strong foundations and growth potential.
Key Criteria for Selecting Fundamentally Good Stocks
Here’s a quick breakdown of essential criteria you should consider when evaluating stocks. These factors span financial health, growth potential, valuation, and management effectiveness.
1. Earnings Per Share (EPS)
Definition: Earnings per share (EPS) is a company’s net profit divided by the number of outstanding shares. It’s a key indicator of profitability on a per-share basis.
Why It Matters: Higher or consistently rising EPS typically signals a profitable company, making it attractive to investors. Check the trend over the past five years to gauge stability.
Benchmark: Look for companies with stable or increasing EPS over several years.
2. Price-to-Earnings (P/E) Ratio
Definition: The P/E ratio compares a company’s stock price to its earnings per share. It shows how much investors are willing to pay per dollar of earnings.
Why It Matters: A low P/E ratio could indicate that a stock is undervalued, while a high P/E might mean it’s overvalued. However, consider industry norms when evaluating the P/E ratio.
Benchmark: Compare the P/E ratio to industry averages and the company’s historical P/E range.
3. Price-to-Book (P/B) Ratio
Definition: The P/B ratio compares a company’s stock price to its book value (assets minus liabilities).
Why It Matters: A low P/B ratio may indicate that a stock is undervalued, especially for asset-heavy industries. It’s also used to assess a company’s market value against its assets.
Benchmark: A P/B ratio below 1.0 often suggests an undervalued stock, but consider the industry standards.
4. Debt-to-Equity (D/E) Ratio
Definition: The D/E ratio measures the company’s total liabilities against shareholders’ equity. It reflects a company’s reliance on debt financing.
Why It Matters: High debt can be risky, especially in economic downturns. A low D/E ratio typically indicates conservative financing, making the company less vulnerable to economic fluctuations.
Benchmark: Seek companies with a D/E ratio below 1.0 for low-risk options. Compare against industry averages, as some sectors (like utilities) naturally carry more debt.
5. Return on Equity (ROE)
Definition: ROE measures profitability by showing how much profit a company generates from each dollar of shareholder equity.
Why It Matters: A high ROE indicates effective management and good use of equity. Consistent ROE growth is a strong signal of financial health and operational efficiency.
Benchmark: Look for companies with ROE above 15% or above industry peers. Consistency in ROE is a positive sign.
6. Current Ratio
Definition: The current ratio compares a company’s current assets to its current liabilities, measuring its ability to cover short-term obligations.
Why It Matters: A high current ratio indicates good liquidity, essential for managing debts and operating expenses. It’s particularly important in unpredictable economic conditions.
Benchmark: A current ratio above 1.5 is generally good, though this varies by industry.
7. Free Cash Flow (FCF)
Definition: Free cash flow is the cash generated after accounting for capital expenditures. It’s a measure of a company’s ability to fund operations, pay dividends, and pursue growth opportunities.
Why It Matters: Companies with strong free cash flow can reinvest in the business, pay off debt, and return money to shareholders. It’s a critical indicator of financial flexibility.
Benchmark: Seek companies with positive, consistent FCF, especially those with increasing FCF over time.
8. Revenue Growth
Definition: Revenue growth shows the increase in a company’s sales over time.
Why It Matters: Consistent revenue growth indicates demand for the company’s products or services and a healthy business model. Companies with stable revenue growth tend to be more resilient in volatile markets.
Benchmark: Look for companies with annual revenue growth of 5% or higher, but assess this relative to industry growth rates.
9. Dividend Yield and Dividend Payout Ratio
Definition: The dividend yield is the annual dividend per share divided by the stock price, while the dividend payout ratio is the percentage of earnings paid to shareholders as dividends.
Why It Matters: Dividend yield provides insights into the returns shareholders receive, while the payout ratio reveals how sustainable the dividends are.
Benchmark: Look for a dividend yield between 2-4% for stable income and a payout ratio below 60%, indicating the company retains enough profit to reinvest and grow.
10. Competitive Advantage (Moat)
Definition: A “moat” is a company’s ability to maintain its market position over competitors. This could be due to brand reputation, proprietary technology, cost advantages, or network effects.
Why It Matters: Companies with strong competitive advantages are more likely to maintain profitability and grow over time, even in competitive industries.
Benchmark: Look for companies with unique products, strong customer loyalty, or high market share, indicating an economic moat.
11. Management and Corporate Governance
Definition: This criterion involves evaluating the company’s leadership team, board of directors, and their strategic vision.
Why It Matters: Effective management and good governance lead to better decision-making and company performance. Look for transparent governance practices, a history of ethical leadership, and strong executive accountability.
Benchmark: Research the CEO’s tenure, past achievements, and alignment with shareholders. High turnover in leadership could be a red flag.
12. Industry and Market Position
Definition: This involves understanding the industry’s growth potential and the company’s position within it.
Why It Matters: Even strong companies struggle in declining industries, while companies in growing industries may benefit from rising demand.
Benchmark: Look for companies in industries with projected growth, and ensure the company holds a competitive position within its market.
13. Analyst Ratings and Institutional Ownership
Definition: Analyst ratings summarize the investment community’s view of a stock, while institutional ownership refers to the percentage of shares held by institutions like banks and mutual funds.
Why It Matters: While not a standalone metric, strong analyst ratings and significant institutional ownership can indicate confidence in the stock’s growth potential.
Benchmark: A “buy” consensus among analysts and high institutional ownership can be positive indicators, though it’s important to conduct your own research.
Cheat Sheet Summary
| Criteria | Definition | Why It Matters | Benchmark |
|---|---|---|---|
| Earnings Per Share (EPS) | Net profit per share | Indicates profitability | Stable or increasing EPS |
| Price-to-Earnings (P/E) | Stock price to earnings per share | Evaluates valuation | Compare to industry average |
| Price-to-Book (P/B) | Stock price to book value | Indicates undervaluation potential | P/B < 1.0 in asset-heavy industries |
| Debt-to-Equity (D/E) | Total liabilities to shareholder equity | Measures risk related to debt | D/E < 1.0, industry-specific |
| Return on Equity (ROE) | Profit generated from equity | Shows management efficiency | ROE > 15% or above peers |
| Current Ratio | Current assets to current liabilities | Indicates liquidity | Current ratio > 1.5 |
| Free Cash Flow (FCF) | Cash remaining after expenses | Measures financial flexibility | Positive, consistent FCF |
| Revenue Growth | Increase in sales over time | Shows demand and business health | 5% annual growth or industry-relative |
| Dividend Yield & Payout | Dividend per share / stock price | Indicates return and sustainability | Yield 2-4%, payout < 60% |
| Competitive Advantage (Moat) | Unique, defensible market position | Helps sustain profitability | Brand loyalty, cost advantage |
| Management & Governance | Leadership team and practices | Affects decision-making and stability | Strong leadership, ethical governance |
| Industry & Market Position | Company’s position in a growing industry | Determines growth potential | High industry growth, strong market position |
| Analyst Ratings & Ownership | Ratings from analysts and institutional ownership | Signals confidence from investment community | Positive ratings, high ownership |
Read More: How to Choose the Best Stocks for Long-Term Investing
Conclusion
Fundamental analysis is essential for selecting stocks with long-term growth potential. By using this cheat sheet as a quick reference, you can assess key financial, operational, and market-based factors to identify fundamentally strong stocks. Always remember that while these criteria provide a robust foundation, conducting your own research and understanding market trends will further improve your investing success.
Dr. Muhammad Jawwad Saif, aka Jawwad, is the founder and the main author at FreeFinEdu. He has a deep passion for finance, particularly in areas that affect everyday individuals and their financial decisions.
Discover more from FreeFinEdu - Free Financial Education
Subscribe to get the latest posts sent to your email.