The world’s investment markets are notorious for their wild swings up and down, but savvy investors know the underlying fundamentals of each business (stock) they buy and they analyze them before purchasing (fundamental analysis). Great investors know WHY they bought and what made the company appealing to them. They know the conditions of the industries they invest in, the management team running the show, and the company’s long-term prospects for the future. They know the numbers, they know at what share price they’ll buy more … and at what has to change for them to sell their shares.
Analyzing a stock’s fundamentals simply means examining a company’s financial numbers to uncover any prospects for the company’s future and to size up its stock value. Your goal when conducting fundamental analysis is to find stocks whose share prices are below where the market should be pricing them. Since markets aren’t always as “efficient” as many experts would have you believe, using fundamental analysis to uncover these undervalued gems can result in superior returns. Another strong benefit of fundamental analysis is that it removes much of the emotion associated with valuing a business and allows investors to make a rational buying or selling decision.
Rarely will you ever find a business with perfect numbers in every category you examine … I know I haven’t! But by actually taking the time to learn about a company’s financial numbers and then determining the market value of it’s stock, I can then decide to buy only when I have a large margin of safety. That is, I buy only when the stock is priced at less than half of what I determine it’s value should be.
Generally, when investors speak of a company’s fundamentals, they’re referring to the company’s financial well-being, as determined by three principle factors:
- Profits (earnings): The total amount of money the company actually earns after expenses
- Debt: The company’s outstanding financial obligations to suppliers, banks, and so on
- Assets: The company’s valuable property, including cash, inventory, real estate, etc.
Data about a company’s fundamentals is easy to find, as every publicly traded company is required to report it quarterly to the SEC. One good place to start is online. I like to use Yahoo! Finance (finance.yahoo.com).
Once you’ve gathered this data, you can use a variety of simple statistics and ratios to assess a company’s fundamentals and determine whether the company’s stock is worth buying. The most commonly used ratios and statistics are:
- Earnings per share (EPS)
- Price-to-earnings (P/E) ratio
- Price-to-earnings-growth (PEG) ratio
- Debt-to-asset ratio
- Price-to-book (P/B) ratio
Fundamental Analysis Example
The best way to understand how to calculate and use these ratios and statistics is through an example. The fictitious company in the example below, Big Red Bullfighting Capes, Inc. (stock symbol “TORO”), has financial numbers as follows:
- Assets: $120,000
- Debts: $20,000
- Publicly traded shares: 1,000
- Share price: $100 per share
- Profits (prior year): $10,000
- Stock dividend payments (prior year): $4 per share
- Projected earnings growth rate (next ten years): 10%
- Beta (explained below): 0.8
Let’s analyze TORO’s fundamentals and the value of its stock:
Earnings Per Share (EPS)
- Definition: The portion of a company’s earnings (profits) that each share of the company’s stock contains.
- How to calculate: Divide earnings by the number of publicly traded shares.
- TORO example: $10,000 in earnings / 1,000 publicly traded shares = $10.
- How to evaluate: If all other factors are equal and two stocks have the same profits, investors generally favor the stock with fewer publicly traded shares and therefore higher EPS.
Price-to-Earnings (P/E) Ratio
- Definition: A way to determine the value of a company’s shares compared to its peers by comparing its current share price to its current EPS.
- How to calculate: Divide the company’s share price by the company’s EPS over a specified period of time.
- TORO example: $100 (share price) / $10 (EPS) = 10 (P/E)
- How to evaluate: Investors generally favor stocks with low P/E ratios relative to other stocks in the same industry. Given two companies in the same industry with the same profits, investors tend to buy the shares of the company with the lower priced stock—in effect, paying a lower price for the same amount of profits. If too many investors flock to the lower stock, however, the price will naturally rise!
Price-to-Earnings-Growth (PEG) Ratio
- Definition: A comparison of a company’s share price to its earnings growth rate. Some investors consider this ratio more useful than the P/E ratio because it factors in futureearnings, not just past earnings.
- How to calculate: Divide a company’s P/E ratio by its projected earnings growth rate (in percentage form).
- TORO example: 10 (P/E) / 10% (earnings growth) = 1
- How to evaluate: If all other factors are equal, given two stocks with the same P/E ratio, investors tend to favor the stock with the lower PEG ratio, since it predicts higher future earnings growth. Investors generally consider stocks with a PEG below 1 to present a good value, though this can vary from industry to industry.
- Definition: A ratio of a company’s assets that have been secured through debt as opposed to equity (assets minus debts).
- How to calculate: Divide the company’s debts by the company’s assets.
- TORO example: $20,000 (debts) / $120,000 (assets) = 0.16
- How to evaluate: A debt-to-asset ratio greater than 1 means that the company’s assets have been financed primarily by debt. Investors favor stocks with debt to asset ratios less than 1, since these companies have fewer liabilities and therefore present less risk.
Price-to-Book (P/B) Ratio
- Definition: A stock’s book value (equal to its equity) gives an indication of what the company is actually worth “on the books” after all debts have been subtracted from assets. A company’s book value is equal to its assets minus its debts. The price-to-book ratio helps investors get a sense of the discrepancy between how the market values a stock and what the stock is actually worth.
- How to calculate: Divide current share price by book value per share (book value divided by number of shares).
- TORO example: TORO’s book value per share = ($120,000 in assets – $20,000 in debts) / 1,000 shares = $100. TORO’s Price to book ratio = $100 (current share price) / $100 (book value per share) = 1.
- How to evaluate: Stocks with P/B ratios equal to 1, such as TORO, show a strong correlation between the company’s underlying value and the value that the market currently places on the stock. A P/B ratio of less than 1 suggests that the market has either overlooked some value in the stock or doubts the value of the company’s underlying assets. Stocks with P/B ratios greater than 1 command a premium from the market. Investors tend to buy these stocks only if they believe that the premium is justified based on actual earnings expectations, as opposed to speculation.
- Definition: A measure of a stock’s historical volatility relative to the broader market’s volatility, which is represented by a beta of 1.
- How to calculate: Calculating a stock’s beta requires advanced math and considerable amounts of data, so consult websites such as Yahoo! Finance to find the latest beta information for stocks you’re researching.
- TORO example: Beta = 0.8
- How to evaluate: Stocks with betas greater than 1 are more volatile than the broader market—they tend to move up and down in price more often and in greater extremes than the market. Stocks with betas of less than 1, such as TORO, tend to be less volatile than the general market. If the market drops by 1%, TORO should drop by 0.8%; however, if the market rises by 1%, TORO should rise by just 0.8%. High beta stocks offer more potential profits to investors but also more risk.You can calculate the average beta of your portfolio stocks to try to keep your holdings in line with your risk tolerance and financial goals. For instance, a portfolio designed to beat the market should have an average beta of greater than 1.
Determining the stock price
You’ll need a few more pieces of data to determine the stock’s value:
- The analyst’s estimated ten year growth rate
- The rate of return you want to achieve
You’ll also need to be able to use and understand Future Value and Present Value calculations. These are both pretty easy to use with a spreadsheet.
I take the analyst’s ten year growth rate and the current EPS and calculate what the EPS should be in ten years. When I calculate that number and then compare it to the P/E ratio for the industry, I’m able to get a rough idea what the stock price should be.
TORO example: The future value of a $10 EPS over the next ten years at a 10% growth rate = $25.94. Many investors conducting fundamental analysis use a P/E ratio of double the growth rate so in our case it would be 20. With that P/E ratio, the stock should be valued at $518.80 in ten years. Now we switch to present value calculations and since I want to achieve a rate of return of 15%, the present value of $518.80 is $128.24. That’s what I value this stock to be today based on the numbers I have available.
To buy or not to buy? I wouldn’t buy this stock unless it’s price dropped to $64.12. Why do I use a 50% margin of safety? I may have made a mistake in my calculations somewhere or I may just have a streak of bad luck! Also, because valuation is an imprecise art, the future is unpredictable, and humans do make mistakes, a large margin of safety insures that I don’t lose money.
In the end, fundamental analysis is much more reliable that other measures in determining whether a business is worthy of my hard earned dollars as an investment. What method or methods do YOU use to make your investing decisions?