Earnings per share (EPS)
Earnings per share is an indicator of corporate profitability and is calculated by dividing net profit by the number of shares available for trading.
The rise in this index gives a positive signal to investors, indicating that the company is making profits and has the potential for future growth, in addition to investors benefiting from the dividend split.
Therefore, investors are watching this index closely and tend to invest in companies with high EPS.
Now that we've discussed the importance of the EPS index, this index will help us calculate another financial ratio that investors are interested in: the price-to-earnings ratio.
P/E ratio
This ratio helps the investor compare the company's share price with its earnings.
The price is calculated on earnings by dividing the share price by the dividend (earnings per share)
When this percentage rises, the share price is high when compared to the company's earnings and vice versa.
Return on Equity
This indicator measures the annual rate of growth among many companies. It is calculated by dividing net income by total equity expressed as a percentage. This ratio helps in analyzing the investment returns of a particular company by comparing it to a benchmark of other companies.
Permanently increasing ROE means that the company is healthy and able to provide a consistent growth ratio to shareholders.
On the contrary, low return on equity means that the company makes poor investment decisions.
Working Capital Ratio
This ratio is calculated by dividing the total current assets by the total current liabilities.
As the name of this indicator indicates, working capital is the capital needed to finance normal operations and meet current payment obligations.
A company with a high working capital ratio will have no problem meeting its financial obligations on time and continuing to run the business smoothly while the low working capital ratio serves as a warning about the company's upcoming financial problems.
However, this ratio should remain balanced as excess working capital can be viewed negatively by investors who may believe that the company is having difficulties reinvesting the additional funds available.
Debt Rights Participation Ratio
This index measures the relationship between total debt and total equity.
This ratio is obtained by dividing the total debt of the company by the financial value of shareholders'
equity.
In practice, the explanation of this variable is quite simple: the higher the ratio, the more debt is used to finance the company's business.
Some investors may see this as a positive sign because these companies may use this debt to start financing new investment projects.
At the same time, a decline in this index suggests more cash flow that could prompt conservative investors to invest in those companies that aim to obtain profits.
Advantages and disadvantages of fundamental analysis
Advantages
Fundamental analysis remains an objective way to deal with financial markets, especially in the stock market, where investment decisions are reached by looking at the financial results of companies and traders follow rational and unbiased decisions that facilitate the decision-making process.
Fundamental analysis helps traders determine the long-term direction of the market and assess companies that have great potential for future growth.
Also, through this type of analysis, investors will be able to rank stocks and leading and lagging sectors.
The goal of fundamental analysis study remains to find a value derived from the financial statements of companies which will then be compared to the current market price to find the mispriced stocks. If the market price is lower than the fair price calculated, the stock is said to be undervalued, so an opportunity to buy may arise. Conversely, if the market price is above the fair price, the stock is said to be high, and therefore should be ignored, or a short selling opportunity can be considered.
Cons
Fundamental analysis is a complex and time-consuming process.
Dealing with too many accounts and too many financial figures can lead to errors. On the other hand, fundamental analysis is practically useless for short-term trading and does not provide solutions to enter the market in time to take advantage of volatile markets with high liquidity.
In addition, fundamental analysis does not offer money management tools (stop-loss and exit levels in case the market changes direction).
Finally, financial markets are irrational due to the psychology and sentiment of investors, often, we see excessive fluctuations in states of fear and greed leading to sharp movements that are unsustainable.
We often notice a drop in the price of a particular stock despite the good news surrounding the company, which keeps this type of analysis vulnerable to unexpected news that can cancel all previous fundamental accounts.
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Forex