Technical analysis and fundamental analysis are the two main schools of thought in the financial markets. Technical analysis looks at the price movement of a security and uses this data to predict its future price movements. Fundamental analysis, on the other hand, looks at economic factors, known as fundamentals. In the previous article we talked about fundamental analysis. In this article we will talk about the five most important variables in fundamental analysis.
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 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.