Lesson 6: Fundamental Analysis | Investing & Options

🔍 What Is Fundamental Analysis?

Fundamental analysis is the process of evaluating a company's financial health, profitability, and growth prospects to determine whether its stock is a good investment at its current price. While technical analysis (Lesson 7) looks at price charts, fundamental analysis looks at the business itself.

The core question fundamental analysis tries to answer: Is this stock worth more or less than what the market is currently charging?

graph LR A["📊 Fundamental Analysis"] --> B["Looks at the business
Revenue, profits, assets, growth"] C["📈 Technical Analysis"] --> D["Looks at the stock price
Charts, patterns, trends, volume"] A --> E["Answers: What should
the stock be worth?"] C --> F["Answers: Where is the
stock price heading?"] style A fill:#10b981,stroke:#059669,color:#fff style C fill:#14b8a6,stroke:#0d9488,color:#fff style E fill:#10b981,stroke:#059669,color:#fff style F fill:#14b8a6,stroke:#0d9488,color:#fff

Many successful investors use both approaches: fundamental analysis to decide what to buy, and technical analysis to decide when to buy it.

📊 The Three Financial Statements

All fundamental analysis ultimately draws from three documents that every public company must publish:

Statement	What It Shows	Key Question It Answers
Income Statement	Revenue, expenses, and profit over a period (quarterly or annually)	Is this company making money?
Balance Sheet	Assets, liabilities, and shareholder equity at a point in time	What does this company own vs. owe?
Cash Flow Statement	Cash coming in and going out from operations, investing, and financing	Is this company generating real cash?

You don't need to be an accountant to use these — we'll focus on the key ratios and metrics that distill these statements into actionable insights.

💰 Earnings Per Share (EPS)

Earnings Per Share (EPS) tells you how much profit a company earns for each outstanding share of stock. It's the single most important number in fundamental analysis because almost every other valuation metric uses it.

💡 EPS Formula

EPS = Net Income ÷ Shares Outstanding

If a company earned $10 billion in net income and has 2 billion shares outstanding, its EPS is $5.00.

Types of EPS

Type	What It Uses	When to Use
Basic EPS	Current shares outstanding	Simple snapshot — doesn't account for dilution
Diluted EPS	Includes potential shares from stock options, convertible bonds, etc.	More conservative and realistic — this is the number most analysts use
Trailing EPS (TTM)	Actual earnings from the past 12 months	Based on real results — backward-looking but concrete
Forward EPS	Analyst estimates for the next 12 months	Forward-looking but speculative — based on projections, not facts

Real-World Example

📊 Comparing EPS Across Companies

Company	Net Income	Shares Outstanding	EPS
Company A	$10 billion	5 billion	$2.00
Company B	$2 billion	500 million	$4.00

Even though Company A earns 5× more total profit, Company B earns twice as much per share. EPS normalizes earnings so you can compare companies of different sizes.

⚠️ EPS Can Be Misleading

A rising EPS doesn't always mean the business is growing. Companies can boost EPS by buying back shares (reducing the denominator) without actually growing earnings. Always check whether EPS growth is driven by revenue growth (good) or share buybacks alone (less impressive). Also watch for one-time gains or charges that can distort a single quarter's EPS.

📐 The P/E Ratio: The Most Popular Valuation Metric

The Price-to-Earnings (P/E) ratio is the most widely used tool for gauging whether a stock is "cheap" or "expensive" relative to its earnings. It tells you how much investors are willing to pay for each dollar of earnings.

💡 P/E Formula

P/E Ratio = Share Price ÷ Earnings Per Share (EPS)

If a stock trades at $100 and its EPS is $5.00, the P/E ratio is 20.
This means investors are paying $20 for every $1 of earnings.

How to Interpret P/E

P/E Range	General Interpretation	Typical Companies
Under 15	Potentially undervalued — or the market expects low growth / problems ahead	Value stocks, banks, energy companies, mature industries
15 – 25	Fair value range for many established companies	Large-cap industrials, consumer staples, healthcare
25 – 40	Premium valuation — market expects strong future growth	Technology leaders, high-growth companies
Over 40	Very high expectations baked in — high risk if growth disappoints	High-flying tech, speculative growth stocks
Negative / N/A	Company is losing money (negative earnings) — P/E doesn't apply	Startups, biotech, companies in turnaround mode

Trailing vs. Forward P/E

Type	Uses	Pros	Cons
Trailing P/E	Past 12 months' actual EPS	Based on real data — no guesswork	Backward-looking — doesn't reflect future changes
Forward P/E	Next 12 months' estimated EPS	Forward-looking — prices in expected growth	Based on analyst estimates that may be wrong

Comparing P/E Ratios

P/E is most useful when comparing:

Comparison	What It Tells You
Stock vs. its own history	Is the stock trading above or below its historical average P/E? If it's usually at 20 and now it's at 35, the market may be overly optimistic.
Stock vs. its peers	Compare within the same sector. A tech stock with P/E 25 might be "cheap" if its competitors average 35.
Stock vs. the S&P 500	The S&P 500 historically averages a P/E around 15–20. A stock with P/E 50 needs strong growth to justify its premium.

⚠️ P/E Pitfalls

A low P/E doesn't automatically mean "buy" — it could mean the company is struggling, in a declining industry, or has one-time earnings that inflated EPS. A high P/E doesn't automatically mean "sell" — it could mean the market correctly anticipates explosive growth. Always ask why the P/E is what it is before drawing conclusions.

📈 Revenue & Earnings Growth

A company's growth rate is arguably more important than its current earnings. Investors pay premium prices for companies that are growing quickly because those earnings should compound over time.

Key Growth Metrics

Metric	Formula	What It Tells You
Revenue Growth (YoY)	(Current Revenue − Prior Year Revenue) ÷ Prior Year Revenue × 100	Is the company selling more? Revenue is the "top line" — it drives everything else.
Earnings Growth (YoY)	(Current EPS − Prior Year EPS) ÷ Prior Year EPS × 100	Is the company becoming more profitable? This is the "bottom line."
Profit Margin	Net Income ÷ Revenue × 100	What percentage of each dollar of revenue becomes profit? Higher is better.

Real-World Growth Comparison

📊 Company Growth Profiles

Metric	Slow & Steady Corp	Rocket Growth Inc
Revenue Growth	5% per year	35% per year
EPS Growth	6% per year	45% per year
Profit Margin	18%	8%
P/E Ratio	14	60
Dividend	3.2%	None

Neither is inherently better — they're different investing approaches. Slow & Steady is a classic value/income stock, while Rocket Growth reinvests all profits into expansion. Your choice depends on your goals, time horizon, and risk tolerance.

What to Look For

Signal	Interpretation
Revenue growing + margins expanding	The best scenario — the company is selling more AND becoming more efficient. Earnings should accelerate.
Revenue growing + margins shrinking	Growing at a cost — could be investing in expansion (okay) or losing pricing power (concerning).
Revenue flat + earnings growing	Cost-cutting driving profits — works short-term but not sustainable forever. You can only cut so much.
Revenue declining	Red flag — the business is shrinking. Unless there's a clear turnaround plan, be very cautious.

💡 The PEG Ratio

The PEG ratio (Price/Earnings to Growth) adjusts P/E for growth rate:

PEG = P/E Ratio ÷ Annual EPS Growth Rate

A PEG of 1.0 means the stock is "fairly valued" for its growth. Under 1.0 could indicate it's undervalued; over 2.0 suggests it may be expensive even after accounting for growth. For example, a stock with P/E 30 and 30% growth has PEG = 1.0 (fair), while P/E 30 with 10% growth has PEG = 3.0 (expensive for its growth rate).

📘 Price-to-Book (P/B) Ratio

The Price-to-Book ratio compares a stock's market price to its book value — the net asset value of the company on its balance sheet.

💡 P/B Formula

P/B = Share Price ÷ Book Value Per Share

Book Value Per Share = (Total Assets − Total Liabilities) ÷ Shares Outstanding

P/B Value	Interpretation
Under 1.0	Stock is trading below the value of its net assets. Could be a bargain — or the market is signaling serious problems.
1.0 – 3.0	Normal range for many industries. The premium above book value reflects intangible value (brand, intellectual property, talent).
Over 3.0	Market is pricing in significant intangible assets or future growth beyond what's on the balance sheet.

📊 When P/B Is Most Useful

P/B works best for asset-heavy companies like banks, insurance companies, and real estate firms, where book value closely reflects the actual value of the business. It's less useful for technology companies, where the real value lies in intellectual property, software, and talent — things that don't show up well on a balance sheet. A company like Microsoft might have a P/B of 12+, which looks "expensive" but makes sense given its massive intangible asset value.

💵 Dividend Yield

A dividend is a cash payment a company makes to shareholders, typically quarterly. Dividend yield tells you what percentage of the stock price you receive as income each year.

💡 Dividend Yield Formula

Dividend Yield = Annual Dividend Per Share ÷ Share Price × 100

If a stock pays $2.00/year in dividends and trades at $50, the yield is 4.0%.

Yield Range	Typical Stocks	What to Know
0%	Growth companies (Amazon, Tesla, Meta for most of its history)	These companies reinvest all profits into growth instead of paying dividends
0.5% – 2%	Large tech (Apple, Microsoft), large-cap growth	Token dividends — the company is primarily a growth story but shares some profit
2% – 4%	Blue chips, consumer staples, healthcare	Solid income — the sweet spot for many income investors
4% – 6%	Utilities, REITs, telecoms, MLPs	High yield — attractive for income but watch for limited growth potential
Over 6%	Varies — can be great value or a warning sign	Very high yields sometimes indicate the stock price has dropped sharply — potentially signaling trouble ahead. The dividend might be cut soon.

Key Dividend Concepts

Term	What It Means
Payout Ratio	Percentage of earnings paid as dividends. Under 60% is healthy for most companies — it means there's room to maintain or grow the dividend even if earnings dip.
Dividend Growth Rate	How fast the company increases its dividend year over year. A company raising its dividend 8% annually will double your income in ~9 years.
Dividend Aristocrats	S&P 500 companies that have increased their dividend for 25+ consecutive years. Examples: Coca-Cola, Johnson & Johnson, Procter & Gamble.
Ex-Dividend Date	The cutoff date — you must own the stock before this date to receive the next dividend payment.

⚠️ The Yield Trap

A very high dividend yield can be a trap. If a stock was $100 paying a $4 dividend (4% yield) and the stock drops to $40, the yield jumps to 10% — but only because the stock crashed. The company may soon cut the dividend because it can no longer afford it. Always check the payout ratio and the company's earnings trend before chasing yield.

⚖️ Debt-to-Equity Ratio

The Debt-to-Equity (D/E) ratio measures how much debt a company uses to finance its operations compared to shareholder equity. It's a key indicator of financial risk.

💡 D/E Formula

D/E Ratio = Total Debt ÷ Shareholders' Equity

If a company has $500M in debt and $1B in equity, its D/E is 0.5.

D/E Range	Interpretation	Context
Under 0.5	Conservative — low financial risk	Company is primarily funded by equity, not debt. Very safe but may be underutilizing leverage.
0.5 – 1.0	Moderate — balanced approach	Healthy for most industries. Using some debt to grow but not excessively.
1.0 – 2.0	Elevated — more reliance on debt	Acceptable in capital-intensive industries (utilities, telecom, real estate) but concerning elsewhere.
Over 2.0	High — significant financial risk	The company owes more than twice its equity. Vulnerable to interest rate increases and economic downturns.

📊 D/E Varies by Industry

Comparing D/E ratios across industries is misleading. Utilities routinely operate with D/E of 1.5–2.0+ because they have stable, predictable revenue to service debt. Tech companies often have D/E under 0.5 because they don't need much capital equipment. Always compare D/E to the company's industry peers, not to an absolute standard.

📋 Other Metrics Worth Knowing

Beyond the core metrics, here are additional ratios you'll encounter in your research:

Metric	Formula	What It Tells You
Return on Equity (ROE)	Net Income ÷ Shareholders' Equity	How efficiently a company uses shareholder money to generate profit. 15%+ is generally strong.
Free Cash Flow (FCF)	Operating Cash Flow − Capital Expenditures	The actual cash left after maintaining/expanding the business. This funds dividends, buybacks, and debt repayment. Some consider FCF more reliable than earnings.
Price-to-Sales (P/S)	Market Cap ÷ Annual Revenue	Useful for unprofitable growth companies where P/E doesn't apply. Lower is generally better.
Current Ratio	Current Assets ÷ Current Liabilities	Can the company pay its short-term bills? Above 1.0 means yes. Well below 1.0 could signal liquidity problems.
Enterprise Value (EV)	Market Cap + Total Debt − Cash	The total "takeover" price of a company. Used in EV/EBITDA, a popular alternative to P/E for comparing companies with different capital structures.

📄 Reading Earnings Reports

Every quarter, public companies release an earnings report detailing their financial performance. These are the single biggest drivers of short-term stock price moves. Understanding what to look for in an earnings report is essential.

The Earnings Calendar

Companies report earnings roughly 2–6 weeks after each quarter ends. "Earnings season" happens four times a year, with most major companies reporting in January, April, July, and October.

graph TD A["📅 Quarter Ends
(Mar 31, Jun 30,
Sep 30, Dec 31)"] --> B["📝 Company prepares
earnings report
(2-6 weeks)"] B --> C["📢 Earnings release
Press release + call
(usually after market close)"] C --> D["📊 Market reacts
Stock moves in
after-hours trading"] D --> E["🔍 Analysts update
estimates & ratings"] style A fill:#10b981,stroke:#059669,color:#fff style C fill:#14b8a6,stroke:#0d9488,color:#fff style D fill:#f59e0b,stroke:#d97706,color:#fff

What to Look For in an Earnings Report

Item	What to Check	Why It Matters
EPS vs. Estimate	Did actual EPS beat, meet, or miss analyst expectations?	The #1 driver of the stock's reaction. Beating estimates = usually stock goes up. Missing = usually drops.
Revenue vs. Estimate	Did actual revenue beat, meet, or miss?	Confirms whether the business is growing. A company can beat on EPS through cost-cutting but miss on revenue — a bad sign.
Guidance	What does the company expect for next quarter/year?	Forward guidance often matters more than the current quarter's numbers. Raised guidance = bullish. Lowered = bearish.
Revenue Growth Rate	Year-over-year percentage change	Is growth accelerating, steady, or decelerating? Decelerating growth — even if still positive — can spook investors.
Margin Trends	Are gross margins and operating margins expanding or contracting?	Expanding margins + revenue growth = the dream scenario. Contracting margins can signal pricing pressure or rising costs.
Earnings Call Commentary	Management's tone, strategic updates, market outlook	The numbers tell you what happened; the call tells you what management thinks will happen next and why.

💡 "Beat and Raise" — The Best Outcome

The most bullish earnings scenario is when a company beats on both EPS and revenue and raises its forward guidance. This trifecta tells the market: "We did better than expected, and we think the future is even brighter than you thought." These reports often send stocks sharply higher.

⚠️ "Buy the Rumor, Sell the News"

Sometimes a stock will rally heading into earnings (on anticipation of good results) and then drop after reporting strong numbers. This happens when the good results were already "priced in" — the market had already bid the stock up in expectation. This is why short-term trading around earnings is risky even with good analysis.

🧩 Putting It All Together

No single metric tells the whole story. The power of fundamental analysis comes from combining multiple metrics to build a complete picture.

A Quick Checklist for Evaluating a Stock

Question	Metric to Check	What You Want to See
Is the company profitable?	EPS, Profit Margin	Positive and growing EPS, healthy margins
Is the stock reasonably priced?	P/E, PEG, P/B	P/E in line with peers; PEG near or under 1.0
Is the business growing?	Revenue Growth, EPS Growth	Consistent growth over multiple quarters/years
Is the company financially healthy?	D/E, Current Ratio, FCF	Manageable debt, positive free cash flow
Does it return value to shareholders?	Dividend Yield, Buybacks, ROE	Growing dividend, strong ROE (15%+)
What do recent results show?	Latest Earnings Report	Beating estimates, positive guidance

graph TD A["🔍 Find a stock
you're interested in"] --> B["💰 Check EPS & P/E
Is it profitable?
Is it reasonably priced?"] B --> C["📈 Check Growth
Revenue & earnings
trending up?"] C --> D["⚖️ Check Financial Health
Debt level? Cash flow?
Payout ratio?"] D --> E["📄 Read Latest Earnings
Beat estimates?
Positive guidance?"] E --> F["🆚 Compare to Peers
Better/worse than
competitors?"] F --> G["✅ Make an Informed
Decision"] style A fill:#10b981,stroke:#059669,color:#fff style G fill:#10b981,stroke:#059669,color:#fff

📊 Start Simple, Add Complexity Later

As a beginner, focus on just four metrics: EPS, P/E, revenue growth, and D/E. These four alone will eliminate most bad investments and highlight promising ones. As you gain experience, layer in additional metrics like PEG, ROE, FCF, and margin analysis. Don't try to master everything at once.

🎯 Key Takeaways

Concept	What to Remember
EPS	Net Income ÷ Shares Outstanding. The foundation of valuation. Use diluted EPS for accuracy.
P/E Ratio	Price ÷ EPS. Compare to peers and history — not in a vacuum. Low P/E ≠ cheap; high P/E ≠ expensive.
Growth	Revenue growth drives long-term value. Watch for revenue + margin expansion together. PEG adjusts P/E for growth.
Dividends	Check the payout ratio, not just the yield. Very high yields can be traps. Dividend Aristocrats have 25+ years of increases.
Debt	D/E ratio measures financial risk. Compare within the same industry. High debt + rising rates = danger.
Earnings Reports	EPS and revenue vs. estimates + forward guidance drive stock reactions. "Beat and raise" is the best outcome.

📝 Knowledge Check

Test your understanding of fundamental analysis metrics.

Question 1: A stock trades at $80 and has an EPS of $4.00. What is its P/E ratio?

4 8 20 320

Question 2: A company has a P/E of 30 and annual EPS growth of 30%. What is its PEG ratio?

0.5 1.0 30 900

Question 3: A stock yields 9% and has a payout ratio of 95%. What should you be cautious about?

The stock is probably undervalued — great buy The company has too little debt The company is growing too fast The high yield may be unsustainable — the dividend could be cut

Question 4: What does "forward guidance" refer to in an earnings report?

The company's projections for future performance A stock's price target set by the CEO The previous quarter's revenue numbers The dividend payment date

Question 5: Why can't you use P/E ratio for a company that is losing money?

P/E only works for tech stocks You need at least 5 years of data for P/E Negative earnings produce a meaningless or negative ratio P/E is only used for ETFs, not individual stocks

⚠️ Important Disclaimer

📋 In This Lesson