Fundamental Analysis
Fundamental analysis looks at the financial profitability of a company. It attempts to determine the true value of a company. By reviewing the balance sheets, income statements, and statements of cash flow can tell how efficiently a company is being run.
These are common metrics:
Earnings per Share – EPS. This is the biggest measure for gauging a company. Earnings are the main driver for a company. The current earnings matter, but the market reacts to the outlook of those earnings going forward. If a company is growing at 20%/yr and then the company reports 15% then the stock is going to be hit hard in the market.
Price/Earnings Ratio – P/E:
Price of the Stock/Earning gives the price of the stock relative to $1 of earnings. This can be used as a comparison between companies in the same industry. You can’t compare a technology company against a grocery store chain. These are commonly used with value investing:
Trailing P/E – This compares the price to the last years’ actual earnings
Forward P/E – This is assumes the next years projected earnings
PEG Ratio – This factors the growth rate to the Price/Earnings ratio.
Price/Book. This measures how expensive a stock is. The current prices per share divided by book value per share for the most recent quarter. A lower number suggests a cheaper value to a value investor.
Price/Sales Ratio: P/S. This takes the price of the stock divided by the revenue. This is a common valuation measurement when buying a company. I like this number to be under 2 if possible
Margins should be as high as possible
Gross Margin. This percentage is the markup on merchandise from its cost: (Revenue – cost of goods sold) / Revenue
Operating Margin. Operating Earnings / Revenue. This measures the company’s ability to meet operating expenses
Pretax Margin. Pretax earnings before tax as a percentage of total sales or revenues.
Net Profit Margin. Net Income / Sales. This tells you how many cents his the bottom line for every dollar of sales. I like to see this number as high as possible.
Balance Sheet
Total Cash Per Share. I consider this an absolute floor for the price for the stock, because if the price of the company is below this number you would buy the entire company for less than cash on hand.
Total Debt/Equity. The Debit/Equity ratio is a measure of the amount of leverage a company has. A company that is expanding will often take on debt. If the company is able to increase revenues higher than the cost of carrying the debt then it is worth the risk. However, the debt must be paid back and will weigh down current earnings.
I prefer companies that have zero debt, because this allows for more flexibility. If there is a hiccup in operations then there is the option to take on some debt to cover. If a restaurant is rapidly expanding and is at 150% and the expansion doesn’t go smooth there is not as much breathing room.
LT Debt/Equity. This is only the longer term debt divided by equity. This takes out the current obligations and inventory fluctuations.
Book Value Per Share. This is a theoretical floor for price of a stock and value investors use this a key measure. The concept is that Mr Market is fickle and you can pick up the company cheap. Then when Mr Market realizes this value you profit.
Current Ratio. (Current Assets / Current Liabilities). This measures a company’s ability to meet short term bills. This should typically 1.0+.
Quick Ratio. (Current Assets – Inventories) / Current Liabilities. This is the Current Ratio pulling out inventories. This is cash on hand to meet payroll and pay short term bills. This should be 1.0+
Quarterly Revenue Growth. This is the main driver for the price of a stock. The market focuses on growth. The stock will react if the actual growth numbers are not what is expected.
Quarterly Earnings Growth. This is should be similar to the revenue growth and the actual earnings should be in line with expected.
EBITDA – Earnings Before Interest Taxes and Amortization. This is a common measure to evaluate the effectiveness of a company.
Market Cap. This is stock price times the number of shares. This is a measure of the size and liquidity of the company.
Management Effectiveness
Return on Assets – ROA. Net Income / Assets. This is a measure of effectiveness of managements ability to produce with the amount of assets at hand. This is useful for companies that have a lot of assets like a utility.
Return On Equity – ROE.
I like this to be as high as possible. Net Income / (Assets – Liabilities = Equity). This is a gauge of the profitability and management of a company. The best opportunities come from companies that have 20% plus. When screening stocks for covered calls I drop this down to 5%, because I’m looking for a company that shows a profit.
Beta. This is a measure of a stock’s reaction to the overall market. Think of this as a percentage. If the market goes up 10% and the stock’s beta is .50 then the stock will be up 5%.
Shares Outstanding. This relates to market capitalization. A small cap would typically have 5 – 50 million shares. This would have a limited supply of stock available and would be more volatile. A company with 1 billion shares takes a lot more money to push the stock $1.00. A large amount of stock would be easier to move in and out of. A large company could also have liquid weekly options and a smaller company may not have any options available at all.
Float. This relates to institutions like mutual funds. Mutual funds impact the prices and move large amounts of capital in and out of a stock.
% Held by Insiders
% Held by Institutions
Dividends. Dividends are a payout to you as an owner of a company and is a significant part of the total return for a stock. Value investors focus on companies that provide a steady yield. Also dividends are currently taxed at a lower rate. There are also stock trading strategies that capture the dividend just for the income.
That are some of the most common indicators used, but is not complete. There are other things that are taken in consideration in finding the true value of a company. Fundamental analysis tends to have a longer view and will have a more holistic approach.
Fundamental analysis can consider demographics, economic indicators, and a company’s approach to business. As an example consider a story stock or type of investing. Peter Lynch of Fidelity Magellan mutual fund made this famous. He liked companies that had a compelling business model. He would find a company and hold fast during an expansion.