Fundamental analysis is a method used to determine the value of a stock by analyzing the financial data that is ‘fundamental’ to the company. That means that fundamental analysis takes into consideration only those variables that are directly related to the company itself, such as its earnings, its dividends, and its sales. Fundamental analysis does not look at the overall state of the market nor does it include behavioral variables in its methodology. It focuses exclusively on the company’s business in order to determine whether or not the stock should be bought or sold.
Critics of fundamental analysis often charge that the practice is either irrelevant or that it is inherently flawed. The first group, made up largely of proponents of the efficient market hypothesis, say that fundamental analysis is a useless practice since a stock’s price will always already take into account the company’s financial data . In other words, they argue that it is impossible to learn anything new about a company by analyzing its fundamentals that the market as a whole does not already know, since everyone has access to the same financial information. The other major argument against fundamental analysis is more practical than theoretical. These critics charge that fundamental analysis is too unscientific a process, and that it’s difficult to get a clear picture of a company’s value when there are so many qualitative factors such as a company’s management and its competitive landscape.
However, such critics are in the minority. Most individual investors and investment professionals believe that fundamental analysis is useful, either alone or in combination with other techniques. If you decide that fundamental analysis is the method for you, you’ll find that a company’s financial statements (its income statement, its balance sheet and its cash flow statement) will be indispensable resources for your analysis . And even if you’re not totally sold on the idea of fundamental analysis, it’s probably a good idea for you to familiarize yourself with some of the valuation measures it uses since they are often talked about in other types of stock valuation techniques as well.
It is often said that earnings are the “bottom line” when it comes to valuing a company’s stock, and indeed fundamental analysis places much emphasis upon a company’s earnings. Simply put, earnings are how much profit (or loss) a company has made after subtracting expenses. During a specific period of time, all public companies are required to report their earnings on a quarterly basis through a 10-Q Report . Earnings are important to investors because they give an indication of the company’s expected dividends and its potential for growth and capital appreciation. That does not necessarily mean, however, that low or negative earnings always indicate a bad stock; for example, many young companies report negative earnings as they attempt to grow quickly enough to capture a new market, at which point they’ll be even more profitable than they otherwise might have been. The key is to look at the data underlying a company’s earnings on its financial statements and to use the following profitability ratios to determine whether or not the stock is a sound investment.
Earnings Per Share
Comparing total net earnings for various companies is usually not a good idea, since net earnings numbers don’t take into account how many shares of stock are outstanding (in other words, they don’t take into account how many owners you have to divide the earnings among). In order to make earnings comparisons more useful across companies, fundamental analysts instead look at a company’s earnings per share (EPS). EPS is calculated by taking a company’s net earnings and dividing by the number of outstanding shares of stock the company has. For example, if a company reports $10 million in net earnings for the previous year and has 5 million shares of stock outstanding, then that company has an EPS of $2 per share. EPS can be calculated for the previous year (“trailing EPS”), for the current year (“current EPS”), or for the coming year (“forward EPS”). Note that last year’s EPS would be actual, while current year and forward year EPS would be estimates.
EPS is a great way to compare earnings across companies, but it doesn’t tell you anything about how the market values the stock. That’s why fundamental analysts use the price-to-earnings ratio, more commonly known as the P/E ratio, to figure out how much the market is willing to pay for a company’s earnings. You can calculate a stock’s P/E ratio by taking its price per share and dividing by its EPS. For instance, if a stock is priced at $50 per share and it has an EPS of $5 per share, then it has a P/E ratio of 10. (Or equivalently, you could calculate the P/E ratio by dividing the company’s total market cap by the company’s total earnings; this would result in the same number.) P/E can be calculated for the previous year (“trailing P/E”), for the current year (“current P/E”), or for the coming year (“forward P/E”). The higher the P/E, the more the market is willing to pay for each dollar of annual earnings. Note that last year’s P/E would be actual, while current year and forward year P/E would be estimates, but in each case, the “P” in the equation is the current price. Companies that are not currently profitable (that is, ones which have negative earnings) don’t have a P/E ratio at all. For those companies you may want to calculate the price-to-sales ratio (PSR) instead.
So is a stock with a high P/E ratio always overvalued? Not necessarily. The stock could have a high P/E ratio because investors are convinced that it will have strong earnings growth in the future and so they bid up the stock’s price now. Fortunately, there is another ratio that you can use that takes into consideration a stock’s projected earnings growth: it’s called the PEG. PEG is calculated by taking a stock’s P/E ratio and dividing by its expected percentage earnings growth for the next year. So, a stock with a P/E ratio of 40 that is expected to grow its earnings by 20% the next year would have a PEG of 2. In general, the lower the PEG, the better the value, because you would be paying less for each unit of earnings growth.
The dividend yield measures what percentage return a company pays out to its shareholders in the form of dividends . It is calculated by taking the amount of dividends paid per share over the course of a year and dividing by the stock’s price. For example, if a stock pays out $2 in dividends over the course of a year and trades at $40, then it has a dividend yield of 5%. Mature, well-established companies tend to have higher dividend yields, while young, growth-oriented companies tend to have lower ones, and most small growing companies don’t have a dividend yield at all because they don’t pay out dividends.
Dividend Payout Ratio
The dividend payout ratio shows what percentage of a company’s earnings it is paying out to investors in the form of dividends. It is calculated by taking the company’s annual dividends per share and dividing by its annual earnings per share (EPS). So, if a company pays out $1 per share annually in dividends and it has an EPS of $2 for the year, then that company has a dividend payout ratio of 50%; in other words, the company paid out 50% of its earnings in dividends. Companies that distribute dividends typically use about 25% to 50% of their earnings for dividend payments. The higher the payout ratio, the less confidence the company has that it would’ve been able to find better uses for the money it earned. This is not necessarily either good or bad; companies that are still growing will tend to have lower dividend payout ratios than very large companies, because they are more likely to have other productive uses for the earnings.
The book value of a company is the company’s net worth, as measured by its total assets minus its total liabilities. This is how much the company would have left over in assets if it went out of business immediately. Since companies are usually expected to grow and generate more profits in the future, most companies end up being worth far more in the marketplace than their book value would suggest. For this reason, book value is of more interest to value investors than growth investors. In order to compare book values across companies, you should use book value per share, which is simply the company’s last quarterly book value divided by the number of shares of stock it has outstanding.
Price / Book
A company’s price-to-book ratio (P/B ratio) is determined by taking the company’s per share stock price and dividing by the company’s book value per share. For instance, if a company currently trades at $100 and has a book value per share of $5, then that company has a P/B ratio of 20. The higher the ratio, the higher the premium the market is willing to pay for the company above its hard assets. Price-to-book ratio is of more interest to value investors than growth investors.
Price / Sales Ratio
As with earnings and book value, you can find out how much the market is valuing a company by comparing the company’s price to its annual sales. This measure is known as the price-to-sales ratio (P/S or PSR). You can calculate the P/S by taking the stock’s current price and dividing by the company’s total sales per share for the past year (or equivalently, by dividing the entire company’s market cap by its total sales). That means that a company whose stock trades at $1 per share and which had $2 per share in sales last year will have a P/S of 0.5. Low P/S ratios (below one) are usually thought to be the better investment since their sales are priced cheaply. However, P/S, like P/E ratios and P/B ratios, are numbers that are subject to much interpretation and debate. Sales obviously don’t reveal the whole picture: a company could be selling dollar bills for 90 cents each, and have huge sales but be terribly unprofitable. Because of the limitations, P/S ratios are usually used only for unprofitable companies, since such companies don’t have a P/E ratio .
Return on Equity
Return on equity (ROE) shows you how much profit a company generates in comparison to its book value . The ratio is calculated by taking a company’s after-tax income (after preferred stock dividends but before common stock dividends) and dividing by its book value (which is equal to its assets minus its liabilities). It is used as a general indication of the company’s efficiency; in other words, how much profit it is able to generate given the resources provided by its stockholders. Investors usually look for companies with ROEs that are high and growing.