In this lesson we'll look at the last of the financial statements you should scrutinise, before rounding up by explaining how to put all your analysis together and decide what to trade.
The income statement measures the company's financial performance over a set timeframe. It's based on a fundamental accounting equation:
Effectively, the income statement is an accounting scorecard that illustrates the future profitability of the business, comparing the value of sales made with the cost of making them. Clearly, if making a sale costs you more than you earn from it, you have a fundamental flaw in your business model.
You might see the following items listed in the income statement:
So, having studied all the data and other information surrounding the company, finally it's time to put it all together. As you'll remember, the objective is to value the company, so you can assess whether it currently seems overpriced or underpriced.
By this point, you should be forming an opinion about whether the company seems positioned for growth or not. Does it have hidden potential, or are there pitfalls on the road ahead? Essentially, you're looking to uncover any factors that may influence the company's future, which haven't yet been taken into account by the markets.
This stage of the analytical process isn't an exact science. It's more a case of sitting back and considering all the evidence as a whole, being as objective as possible.
While 'gut feeling' could play a part, it's vital to consider whether you're allowing any personal bias or emotional attachment to sway your judgment. For example, we all have our favourite brands, but your love for a particular company's products doesn't automatically make the stock a good investment.
You can find out more about avoiding bias and other emotional influences in our course, 'The psychology of trading'.
Over time you'll develop your own preferred methods for choosing what to trade. Opinions differ about which data and ratios are the most significant, although some are commonly considered important.
For example, we mentioned the debt/equity ratio earlier in this course, and you might also look at price/sales, a valuation metric calculated by dividing a company's market capitalisation by the most recent revenue number.
As the level of the share price is central to fundamental analysis, many analysts use ratios that include the current price. Keep in mind that a company's stock price is equal to its market capitalisation divided by the number of shares issued.
Having selected a share that you believe shows potential, the only remaining decision is how to trade it. There are two aspects to this:
The first is simply a case of deciding whether you expect the share price to rise or to fall. The second depends both on your own goals - a fast profit, or gradual growth and dividend income - and on your expectations of the company.