FUNDAMENTAL
ANALYSIS TOOLS
These are the most popular tools of fundamental analysis.
They focus on earnings, growth, and value in the market. For convenience, I
have broken them into separate articles. Each article discusses related ratios.
There are links in each article to the other articles and back to this article.
The articles are:
A Good Company with a Bad P/E Good company, but risky
stock?
Like a smooth-talking brother-in-law who always
makes his latest get-rich-quick scheme sound like a sure thing, good companies
can be risky investments.
If the idea of a good company being a risky
investment sounds incongruous to you, consider this scenario.
Acme Cumquats is a cash machine. Investors are
dazzled by how the management is able to find new markets for cumquats.
Cash pours into the company and is turned into
record profits, quarter after quarter.
Good Company, Good Investment
For a good company to be
a good investment, it must be priced (valued) correctly.
Investors gain from a stock investment by buying
at a price that is below the actual value. Over time, a good company will
reward the investor with dividends and growth in the stock’s price.
If that is all there was, valuation would be
much easier. However, there is another factor to consider.
Investors eager to get a piece of the action may
bid up the stock’s price to a level where future price appreciation is
uncertain.
Ignoring dividends for a minute, you can get a
rough idea of valuation by multiplying the earnings per share (EPS) by the
price earnings ratio (P/E).
P/E Factor
Remember P/E is a factor
of how much investors are willing to pay for earnings.
So if a company is earning $2 per share and the P/E
is 25, the stock should be worth $50 per share. If earning don’t change, but
the P/E drops to 20 (meaning investors are not so excited about the company’s
future prospects), the stock should now be worth $40 per share.
This is the problem of paying too much for the
stock - if investor sentiment turns - the stock falls. Investors can’t predict
what the market will do and how that might influence the stock’s price.
Focusing on buying a stock at a discount to its worth as an operating company
will help protect you from speculative influences on market price.
Of course, P/E is not the only or even the best
measure of a stock’s true value, but it does illustrate why buying high is a
dangerous strategy.
One of the challenges of evaluating stocks is establishing an “apples to
apples” comparison. What I mean by this is setting up a comparison that is
meaningful so that the results help you make an investment decision. Comparing the price of two stocks is
meaningless as I point out in my article “Why Per-Share Price is Not Important.”
Similarly, comparing the earnings of one company
to another really doesn’t make any sense, if you think about it. Using the raw
numbers ignores the fact that the two companies undoubtedly have a different
number of outstanding shares.
For example, companies A and B both earn $100,
but company A has 10 shares outstanding, while company B has 50 shares
outstanding. Which company’s stock do you want to own?
It makes more sense to look at earnings per
share (EPS) for use as a comparison tool. You calculate earnings per share by
taking the net earnings and divide by the outstanding shares.
EPS = Net Earnings / Outstanding Shares
Using our example above, Company A had earnings of $100 and 10 shares
outstanding, which equals an EPS of 10 ($100 / 10 = 10). Company B had earnings
of $100 and 50 shares outstanding, which equals an EPS of 2 ($100 / 50 = 2).
So, you should go buy Company A with an EPS of
10, right? Maybe, but not just on the basis of its EPS. The EPS is helpful in
comparing one company to another, assuming they are in the same industry, but
it doesn’t tell you whether it’s a good stock to buy or what the market thinks
of it. For that information, we need to look at some ratios.
Before we move on, you should note that there
are three types of EPS numbers:
·
Trailing EPS – last year’s numbers and the only actual EPS
·
Current EPS – this year’s numbers, which are still projections
·
Forward EPS – future numbers, which are obviously projections
Understanding Price to Earnings Ratio
If there is one number
that people look at than more any other it is the Price to Earnings Ratio
(P/E). The P/E is one of those numbers that investors throw around with great
authority as if it told the whole story. Of course, it doesn’t tell the whole
story (if it did, we wouldn’t need all the other numbers.)
The P/E looks at the relationship between the
stock price and the company’s earnings. The P/E is the most popular metric of
stock analysis, although it is far from the only one you should consider.
You
calculate the P/E by taking the share price and dividing it by the company’s EPS.
P/E = Stock Price / EPS
For example, a company with a share price of $40
and an EPS of 8 would have a P/E of 5 ($40 / 8 = 5).
What does P/E tell you? The P/E gives you an
idea of what the market is willing to pay for the company’s earnings. The
higher the P/E the more the market is willing to pay for the company’s
earnings. Some investors read a high P/E as an overpriced stock and that may be
the case, however it can also indicate the market has high hopes for this
stock’s future and has bid up the price.
Conversely, a low P/E may indicate a “vote of no
confidence” by the market or it could mean this is a sleeper that the market
has overlooked. Known as value stocks, many investors made their fortunes
spotting these “diamonds in the rough” before the rest of the market discovered
their true worth.
What is the “right” P/E? There is no correct
answer to this question, because part of the answer depends on your willingness
to pay for earnings. The more you are willing to pay, which means you believe
the company has good long term prospects over and above its current position,
the higher the “right” P/E is for that particular stock in your decision-making
process. Another investor may not see the same value and think your “right” P/E
is all wrong. The articles in this series:
UNDERSTANDING THE PEG
The P/E is the most popular way to compare the
relative value of stocks based on earnings because you calculate it by taking
the current price of the stock and divide it by the Earnings Per Share (EPS).
This tells you whether a stock’s price is high or low relative to its earnings.
Some investors may consider a company with a
high P/E overpriced and they may be correct. A high P/E may be a signal that
traders have pushed a stock’s price beyond the point where any reasonable near
term growth is probable.
However, a high P/E may also be a strong vote of
confidence that the company still has strong growth prospects in the future,
which should mean an even higher stock price.
Because the market is usually more concerned
about the future than the present, it is always looking for some way to project
out. Another ratio you can use will help you look at future earnings growth is
called the PEG ratio. The PEG factors in projected earnings growth rates to the
P/E for another number to remember.
You calculate the PEG by taking the P/E and
dividing it by the projected growth in earnings.
PEG = P/E / (PROJECTED GROWTH IN
EARNINGS)
For example, a stock with a P/E of 30 and
projected earning growth next year of 15% would have a PEG of 2 (30 / 15 = 2).
What does the “2” mean? Like all ratios, it
simply shows you a relationship. In this case, the lower the number the less
you pay for each unit of future earnings growth. So even a stock with a high
P/E, but high projected earning growth may be a good value.
Looking at the opposite situation; a low P/E
stock with low or no projected earnings growth, you see that what looks like a
value may not work out that way. For example, a stock with a P/E of 8 and flat
earnings growth equals a PEG of 8. This could prove to be an expensive
investment.
A few important things to remember about PEG:
It is about year-to-year earnings growth It relies on projections, which may not always be accurate
P/S = Market Cap / Revenues
or P/S = Stock Price / Sales Price Per Share
Much like P/E, the P/S number reflects the value
placed on sales by the market. The lower the P/S, the better the value, at
least that’s the conventional wisdom. However, this is definitely not a number
you want to use in isolation. When dealing with a young company, there are many
questions to answer and the P/S supplies just one answer.
Understanding Price to Book Ratio
Investors looking for
hot stocks aren’t the only ones trolling the markets. A quiet group of folks
called value investors go about their business looking for companies that the
market has passed by.
Some of these investors become quite wealthy
finding sleepers, holding on to them for the long term as the companies go
about their business without much attention from the market, until one day they
pop up on the screen, and some analyst “discovers” them and bids up the stock.
Meanwhile, the value investor pockets a hefty profit.
Value investors look for some other indicators
besides earnings growth and so on. One of the metrics they look for is the
Price to Book ratio or P/B. This measurement looks at the value the market
places on the book value of the company.
You calculate the P/B by taking the current
price per share and dividing by the book value per share.
P/B = Share Price / Book Value Per Share
Like the P/E, the lower the P/B, the better the
value. Value investors would use a low P/B is stock screens, for instance, to
identify potential candidates.
Understanding
Dividend Payout Ratio
There are some metrics
used in fundamental analysis that fall into what I call the “ho-hum” category.
The Dividend Payout Ratio (DPR) is one of those
numbers. It almost seems like a measurement invented because it looked like it
was important, but nobody can really agree on why.
The DPR (it usually doesn’t even warrant a
capitalized abbreviation) measures what a company’s pays out to investors in
the form of dividends.
You calculate the DPR by dividing the annual
dividends per share by the Earnings Per Share.
DPR = Dividends Per Share / EPS
For example, if a company paid out $1 per share
in annual dividends and had $3 in EPS, the DPR would be 33%. ($1 / $3 = 33%)
The real question is whether 33% is good or bad
and that is subject to interpretation. Growing companies will typically retain
more profits to fund growth and pay lower or no dividends.
Companies that pay higher dividends may be in
mature industries where there is little room for growth and paying higher
dividends is the best use of profits (utilities used to fall into this group,
although in recent years many of them have been diversifying).
Either way, you must view the whole DPR issue in
the context of the company and its industry. By itself, it tells you very
little.
Understanding Dividend Yield
Not all of the tools of
fundamental analysis work for every investor on every stock. If you are looking
for high growth technology stocks, they are unlikely to turn up in any stock screens you run looking for dividend
paying characteristics.
However, if you are a value investor or looking
for dividend income then there are a couple of measurements that are specific
to you. For dividend investors, one of the telling metrics is Dividend Yield.
This measurement tells you what percentage
return a company pays out to shareholders in the form of dividends. Older,
well-established companies tend to payout a higher percentage then do younger
companies and their dividend history can be more consistent.
You calculate the Dividend Yield by taking the
annual dividend per share and divide by the stock’s price.
Dividend Yield = annual dividend per
share / stock's price per share
For example, if a company’s annual dividend is
$1.50 and the stock trades at $25, the Dividend Yield is 6%. ($1.50 / $25 =
0.06)
Understanding Book Value
How much is a company
worth and is that value reflected in the stock price?
There
are several ways to define a company’s worth or value. One of the ways you
define value is market cap or
how much money would you need to buy every single share of stock at the current
price.
Another way to determine a company’s value is to
go to the balance statement and look at the Book Value. The Book Value is
simply the company’s assets minus its liabilities.
Book Value = Assets - Liabilities
In other words, if you wanted to close the
doors, how much would be left after you settled all the outstanding obligations
and sold off all the assets.
A company that is a viable growing business will
always be worth more than its book value for its ability to generate earnings
and growth.
Book
value appeals more to value investors who look at the relationship to the
stock's price by using the Price to Book ratio.
To compare companies, you should convert to book
value per share, which is simply the book value divided by outstanding shares.
UNDERSTANDING RETURN ON EQUITY
If you give some
management teams a couple of boards, some glue, and a ball of string, they can
build a profitable growing business, while other teams can’t make a profit with
several billion dollars worth of assets.
Return on Equity (ROE) is one measure of how
efficiently a company uses its assets to produce earnings. You calculate ROE by
dividing Net Income by Book Value. A healthy company may produce an ROE in the
13% to 15% range. Like all metrics, compare companies in the same industry to
get a better picture.
While ROE is a useful measure, it does have some
flaws that can give you a false picture, so never rely on it alone. For
example, if a company carries a large debt and raises funds through borrowing
rather than issuing stock it will reduce its book value. A lower book value
means you’re dividing by a smaller number so the ROE is artificially higher. There
are other situations such as taking write-downs, stock buy backs, or any other
accounting slight of hand that reduces book value, which will produce a higher
ROE without improving profits.
It may also be more meaningful to look at the
ROE over a period of the past five years, rather than one year to average out
any abnormal numbers.
Given that you must look at the total picture,
ROE is a useful tool in identifying companies with a competitive advantage. All
other things roughly equal, the company that can consistently squeeze out more
profits with their assets, will be a better investment in the long run.
No single number from this list is a magic bullet that will
give you a buy or sell recommendation by itself, however as you begin
developing a picture of what you want in a stock, these numbers will become
benchmarks to measure the worth of potential investments.
The first step
for you to understand the stock market is to understand stocks.
A share of stock is the smallest unit of
ownership in a company. If you own a share of a company’s stock, you are a part
owner of the company.
You have the right to vote on members of the
board of directors and other important matters before the company. If the
company distributes profits to shareholders, you will likely receive a
proportionate share.
One of the unique features of stock ownership is
the notion of limited liability. If the company loses a lawsuit and must pay a
huge judgment, the worse that can happen is your stock becomes worthless. The
creditors can’t come after your personal assets. That’s not necessarily true in
private-held companies.
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