Fundamental Analysis

The purpose of fundamental analysis is to determine the fair value of a company.

Value investors such as Warren Buffett use stock metrics and financial ratios to help identify undervalued stocks.

Value investors believe that good and bad news and market hype can cause the stock’s price to deviate from it’s fundamental true value, presenting buying opportunities.

Some of the most important stock metrics and financial ratios are:

Earning per Share (EPS)

• This is a company’s earnings divided by the number of shares outstanding.
• EPS is generally reported in annualized form for the most recent fiscal year. You will often see the abbreviation (ttm) associated with earnings per share. That means that the earnings number is a sum of the previous four quarters, which is not necessarily the same as the previous fiscal year.
• Notes: (1) A publicly traded company discloses its EPS four times a year in quarterly earnings reports on the income statement. After the last quarter of its fiscal year (which may or may not be the same as the calendar year) it releases an annual report that shows its earnings over the fiscal year.
• (2) On the income statement a company will report both basic and diluted EPS. Dilutive shares outstanding are shares that can be converted to common stock. (3) Diluted EPS is considered a conservative metric because it indicates a worst-case scenario in terms of EPS.

Price-to-Earnings Ratio (P/E Ratio)

• This is a first glance look at whether a stock is overvalued or undervalued.
• There are different P/E ratios for a stock depending on how earnings are calculated. Earnings can be based on historical earnings or future (forward) estimates of earnings.
• Most common are to use the trailing twelve months – P/E (ttm) and a forward P/E based on analysts estimates.
• The P/E ratio doesn’t factor in earnings growth. For this see PEG ratio.
• To help understand P/E, note that one divided by the P/E * 100 (which is 100 * E/P) is the percent of earnings you would expect to make on your inverstment. For example if you bought a company with a P/E of 20, you would expect to make 100 * (1/20) = 5% per year on your investment.
• Acceptable P/E ratios are different for different sectors and industries and have varied historically. For example the S&P 500 P/E is currently around 23. It was 19 a year ago. In May 2009, the P/E ratio reached a staggering 123.73, the highest ratio in United States history. From 1973 to 1985, the P/E ratio tracked close to 10.

PEG Ratio (P/E to earnings growth ratio)

• Unlike the P/E ratio, the PEG ratio takes into account the earnings growth of a company.
• The PEG ratio gives a better picture of whether a stock’s price is overvalued or undervalued by analyzing both historical earnings and the expected growth rate of earnings in the future.
• A stock with a PEG of less than 1 is considered to be undervalued since its price is low compared to the company’s expected earnings growth. A PEG greater than 1 is considered to be overvalued since the stock’s price is high compared to the company’s expected earnings growth.

Price to Book Ratio (P/B)

• The Book Value of a company in it’s net value calculated as Assets – Liabilities. Divide that by the number of shares outstanding, and we get the Book Value per Share (BVPS).
• The Price to Book Ratio is the Price divided by the BVPS.
• The Price to Book ratio is a good indication of what investors are willing to pay for each dollar of a company’s net value.
• A P/B of 1 means the stock is trading at book value. A P/B ratio of 0.5 means that the market value that the stock is trading at is one-half of the company’s stated book value. The indicates the stock in undervalued. Similarly, a P/B value of 1.5 means the stock is expensive based on it’s book value

Debt to Equity Ratio (D/E)

• The Debt to Equity Ratio shows how much debt a company is carrying compared to it’s shareholder equity. Too much debt can pose a risk to a company if it is not managed properly.
• Acceptible Debt to Equity Ratio’s vary from industry to industry. For example industries with a lot of fixed assets have higher ratios than companies in other industries.

Free Cash Flow (FCF)

• FCF is the amount of cash left over from it’s revenue after it pays it’s operating expenses and capital expendures.
• Increasing free cash flow is a good indicator to expect increased earnings, and increasing stock prices.

Working Capital Ratio

• Working capital = current assets – current liabilities.
• The Working Capital Ratio = current assets / current liabilities.
• If the Working Capital Ratio is 2 or higher, then this usually indicates healthy liquidity and the ability to pay short-term liabilities. However there are many other factors to consider.

Quick Ratio

• the Quick Ratio = current assets – inventory – prepaid expenses / current liabilities.
• It is a measure of liquidity, and represents a company’s ability to pay current liabilities with assets that can be converted to cash quickly.
• A quick ratio of less than 1 can indicate that there aren’t enough liquid assets to pay short-term liabilities.

Return on Equity (ROE)

• This metric measures how effectively a company uses shareholder equity to generate income.
• An increasing ROE indicates that a company is doing a good job of using shareholder funds to increase profits.