Fundamentals of Stock Market: Tutorial-3

Types of Analysis:

The methods used to analyze securities and make investment decisions fall into two very broad categories: fundamental analysis and technical analysis. Fundamental analysis involves analyzing the characteristics of a company in order to estimate its value. Technical analysis takes a completely different approach; it doesn’t care one bit about the “value” of a company or a commodity. Technicians (sometimes called chartists) are only interested in the price movements in the market.

Despite all the fancy and exotic tools it employs, technical analysis really just studies supply and demand in a market in an attempt to determine what direction, or trend, will continue in the future. In other words, technical analysis attempts to understand the emotions in the market by studying the market itself, as opposed to its components. If you understand the benefits and limitations of technical analysis, it can give you a new set of tools or skills that will enable you to be a better trader or investor.

In this tutorial, we’ll introduce you to the tools of fundamental analysis. It’s a broad topic, so we’ll just cover the basics, providing you with the foundation you’ll need to understand more advanced concepts down the road.

Tools of Fundamental Analysis:

Fundamental analysis is the process of looking at a business at the basic or fundamental financial level. This type of analysis examines key ratios of a business to determine its financial health and gives you an idea of the value its stock. Many investors use fundamental analysis alone or in combination with other tools to evaluate stocks for investment purposes. The goal is to determine the current worth and, more importantly, how the market values the stock. This article focuses on the key tools of fundamental analysis and what they tell you. Even if you don’t plan to do in-depth fundamental analysis yourself, it will help you follow stocks more closely if you understand the key ratios and terms.

The basic tools are:

 

1)         Earnings per Share – EPS

2)         Price to Earning Ratio (P/E Ratio)

3)         Projected Earning Growth – PEG

4)         Price to Sell – P/S

5)         Price to Book – P/B

6)         Dividend Payout Ratio

7)         Dividend Yield

         Book Value

9)         Return on Equity

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.

1)  Earnings per Share – EPS:

EPS = Net Earnings / Outstanding Shares

Using our example above, Company A had earnings of Rs100 and 10 shares outstanding, which equals an EPS of 10 (Rs100 / 10 = 10). Company B had earnings of Rs100 and 50 shares outstanding, which equals an EPS of 2 (Rs100 / 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.

2)  Price to Earning Ratio (P/E Ratio)

P/E = Stock Price / EPS

For example, a company with a share price of Rs 40 and an EPS of 8 would have a P/E of 5 (Rs40 / 8 = 5).

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

3)  Projected Earning Growth – PEG:

PEG = Price per Earnings / (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

4)  Price to Sell – P/S:

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 knowledge. 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.

5)  Price to Book – P/B

Value investors use these indicators besides earnings growth. 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.

6)  Dividend Payout Ratio:

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 Rs1 per share in annual dividends and had Rs3 in EPS, the DPR would be 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 grown-up 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.

7)  Dividend Yield:

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 Rs1.50 and the stock trades at RS25, the Dividend Yield is 6%.

  Book Value:

One 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.

9)  Return on Equity:

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.

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