Long-term trading: focus on the fundamentals

If you are a long-term investor, you need to analyse companies in your short list in much more detail.

You will be less concerned with news that might move a company's share price over the short or medium term – for example, a single earnings release or change to its full-year outlook – but are more concerned with the overall financial health of the company.

You are essentially looking to see whether the fundamentals of each company are able to sustain a rise in its share price over a long period of time.

To help you decide which shares to invest in, work through the following steps:

Step 1: determine your stocks' real value

The first step in deciding which company to invest in for the long term is to work out which shares are currently undervalued or overvalued. You can then make a decision on them eventually returning to a price that reflects their true value.

To do this, look at each company's earnings report and calculate the following ratios:

Financial health ratios

Using financial health ratios will tell you if a company has ample money to pay its costs or is in danger of going bankrupt. Start with the following financial health ratios, using data from the past two to five years: Current ratio, quick ratio and 'debt to equity ratio'.

Performance/efficiency ratios

A company's financial performance ratios will give you an idea of how efficient its management is at making the most of the capital and assets at hand. Start by analysing the following: 'Return on equity' and 'return on capital employed'.

Evaluation ratios

Evaluation ratios tell you if a company appears to be undervalued or overvalued. Start by analysing the 'price to earnings' ratio.

Step 2: record your data

Record all this information, creating a detailed file on each company.

Because ratios give you a concrete number to work with, they are also a simple way of comparing different companies in the same sector.

For this reason, you might want to create a spreadsheet containing key ratios for a number of companies, all in one place.

Step 3: analyse your data

To decide whether the shortlist of companies you are interested in represent a good investment prospect, work through the following checklist:

• Look at each company's share price performance compared with that of the index it trades on and also its sector – this will tell you whether the company seems to be underperforming or overperforming its peers.
• If it appears to have been underperforming other companies in its sector or market, ask yourself why – look again at its financial ratios to try and decide whether it is undervalued (and therefore might see its price rise) or simply inefficient.
• Look at changes in each company's financial, performance and evaluation ratios over the past two to five years – look for trends that show you its financial health or performance is improving or worsening.
• Compare evaluation data with what you can find out from each company's balance sheet and in the news. If, for example, evaluation methods suggest that it is overvalued, worsening earnings or a weak take-up of its products might confirm this.
• Consider each company's performance ratios in context of its current plans – if its management is actively working to cut costs and seems to have made some headway, for example, you might choose to be less deterred by a low return on capital or equity.
• Use financial health to categorise companies you are interested in as high risk, moderate risk or low risk – this will provide you with some context to view other ratios in.
• If, for example, a company's financial health ratio suggests it is high risk, its performance ratio is also weak and evaluation methods suggest it is overvalued, this might be a stock to avoid.

Another way of refining your list is to grade companies using a system – for example 1 to 5, with 1 meaning strong potential and 5 meaning low potential.

Step 4: choose your stocks

Once you have taken all the above into account and applied it to your shortlist of stocks, you should have identified two or three stocks that you want to go ahead and invest in.

Remember however that as with any form of fundamental analysis, every stage in the above process involves a level of subjectivity.

There is no 'one size fits all' method for choosing which stocks to invest in, but as you gain in experience you will find through trial and error which ways work best for you.