12 February 2012 21:00

5 Important Elements in Fundamental Analysis

Having a basic knowledge of fundamental analysis will give you a better foundation for your investment decisions. Learn 5 core elements in Fundamental Analysis and understand why you should use it when investing. You will learn how to find relevant information in earning reports from the listed companies. 

This article provides a guideline on where to start when doing fundamental analysis. It covers the following aspects and elaborates on the principles:

  • What is fundamental analysis?
  • Why use fundamental analysis?
  • The true value of a stock?
  • 5 key factors to look for
  • Buying at the right price

Article: FA 470x315

 

Fundamental analysis is critical component in stock analysis. It is quite accessible, extremely valuable and you actually don't need a finance degree to get a basic understanding of it. The problem of fundamental analysis is however that it can very easily get quite complicated, but it doesn't have to be.

 

What is a Fundamental Analysis?

A fundamental analysis is all about getting an understanding of a company, the health of its business and its future prospects. It includes reading and analyzing annual reports and financial statements to get an understanding of the company's comparative advantages, competitors and its market environment.


Why use fundamental analysis?
Fundamental analysis is built on the idea that the stock market may price a company wrong from time to time. Profits can be made by finding underpriced stocks and waiting for the market to adjust the valuation of the company. By analyzing the financial reports from companies you will get an understanding of the value of different companies and understand the pricing in the stock market.

After analyzing these factors you have a better understanding of whether the price of the stock is undervalued or overvalued at the current market price. Fundamental analysis can also be performed on a sectors basis and in the economy as a whole.

 

The true value of a stock?

For a fundamental analyst, the market price of a stock tends to move towards its 'intrinsic value', which is the 'true value' of a company as calculated by its fundamentals. If the market value does not match the true value of the company, there is an investment opportunity.

Example of this is that if the current market price of a stock is lower than the intrinsic price, the investor should purchase the stock because he expects the stock price to rise and move towards its true value. Alternatively, if the current market price is above the intrinsic price, the stock is considered overbought and the investor sells the stock because he knows that the stock price will fall and move closer to its intrinsic value. To determine the true price of the company's stock, the following factors need to be considered.

 


5 key factors to look for


 

1. Earnings

The key element all investors look after is earnings. Before investing in a company you want to know how much the company is making in profits. Future earnings are a key factor as the future prospects of the company's business and potential growth opportunities are determinants of the stock price.

Factors determining earnings of the company are such as sales, costs, assets and liabilities. A simplified view of the earnings is earnings per share (EPS). This is a figure of the earnings which denotes the amount of earnings for each outstanding share.

 

2. Profit Margins

Amount of earnings do not tell the full story, increasing earnings are good but if the cost increases more than revenues then the profit margin is not improving. The profit margin measures how much the company keeps in earnings out of every dollar of their revenues. This measure is therefore very useful for comparing similar companies, within the same industry.

FA Formula 1

Higher profit margin indicates that the company has better control over its costs than its competitors. Profit margin is displayed in percentages and a 10 percent profit margin denotes that the company has a net income of 10 cents for each dollar of their revenues.
To get better understanding of profit margins it is good to compare two companies with alternative margins, see table below.

 

 FA Table 1

 

3. Return on Equity (ROE)

Return of equity (ROE) is a financial ratio that does not account for the stock price. Since it ignores the price entirely it is by many thought of as THE most important financial measure. It can basically be thought of as the parent ratio that always needs to be considered.

This ratio is a measure of how efficient a company is in generating its profits. It is a ratio of revenue and profits to owners' equity (shareholders are the owners). Specifically it is: 

FA Formula 2

An easy example of this is that if company A and company B both generate net profits of $1 Million but company A has equity of $10 Million but company B has equity of $100 Million. Their ROE would be 10% and 1% respectively meaning that company A is more efficient as it was able to produce the same amount of earnings with 10 times less equity. 

 

FA Table 2


The reason for why this measure is so important is because it contains information about several factors, such as:

  • Leverage (which is the debt of the company)
  • Revenue, profits and margins
  • Returning values to shareholders

Good approximation is that ROE should be 10-40% greater than its peer.

 

4. Price-to-Earnings (P/E)

When taking the current market price into consideration, the most popular ratio is the Price-to-Earnings (P/E) ratio. As the name suggest it is the current market price divided by its earnings per share (EPS). It is an easy way to get a quick look of a stock's value.

A high P/E indicates that the stock is priced relatively high to its earnings, and companies with higher P/E therefore seem more expensive. However, this measure, as well as other financial ratios, needs to be compared to similar companies within the same sector or to its own historical P/E. This is due to different characteristics in different sectors and changing markets conditions.

This ratio does not tell the full story since it does not account for growth. Normally, companies with high earnings growth are traded at higher P/E values than companies with more moderate growth rate. Accordingly, if the company is growing rapidly and is expected to maintain its growth in the future this current market price might not seem so expensive.  This is the reasoning for the existence of different investment styles; Value vs. Growth stocks.  

Example
While some sectors normally have low P/E measures, other sectors commonly have higher ratios. For example, utilities commonly have P/E ranging from 5 to 10 while technology companies commonly have a P/E ratio ranging from 15 to 20 or above. This is due to expectations in the market about the sector and its earnings-growth possibilities. The utility sector has stable earnings and is not expected to grow rapidly while technology companies are expected to grow faster and tend to need less capital for its growth. 

In order to simplify, the following table illustrates four companies in two sectors  with alternative figures.

FA table Companies

It is not very appropriate to compare Apple with GDF Suez as Apple has a growth rate of 11 times more than GDF. It is more appropriate to compare Apple with Google. In that relation, Apple seems cheaper than Google by the look of the P/E. Now you should ask why that could be? -is this bargain or are some other reason why Apple is priced lower than Google. One suggestion might be that the market expects Google to have more earnings-growth in the coming future and Apple's previous earnings growth is not expected to grow much further. 

 

In order to account for growth, the P/E ratio can be modified into the Price/Earnings to Growth (PEG) ratio. A PEG ratio is calculated by dividing the stock's P/E ratio by its expected 12 month growth rate. A common rule of thumb is that the growth rate ought to be roughly equal to the P/E ratio and thus the PEG ratio should be around 1. A relatively low PEG ratio indicates an undervalued stock and a PEG ratio much greater than 1 indicates an overvalued stock.

The PEG ratio can be very informative figure, especially for fast growing and cyclical companies. In this one ratio you get an understanding of the company's earnings, growth expectations and whether it is trading at a reasonable price relative to its fundamentals.

 

5. Price-to-Book (P/B)

A price-to-book (P/B) ratio is used to compare a stock's market value to its book value. It can be calculated as the current share price divided to the book value per share, according to previous financial statement. In a broader sense, it can also be calculated as the total market capitalization of the company divided by all the shareholders equity.

This ratio gives certain idea of whether you are paying too high price for the stock as it denotes what would be the residual value if the company went bankrupt today.

A higher P/B ratio than 1 denotes that the share price is higher than what the company's assed would be sold for. The difference indicates what investors think about the future growth potential of the company.



Buying at the right price?

In the long run the stock price should reflect its fundamental true value. However in the short run a stock might have great fundamentals but still be moving in wrong direction. This can be due to other factors, such as news releases and changes in future outlook, which also have effect on the price. Trends in the market and investors emotions also effect the short-term fluctuation in stock prices resulting in the current market price deviating from its true value.

One question that is important to consider is: "What is the difference between a great business and a great investment?" -the answer is "price". If you pay too high price for even the best stock in the world, you will never make a good return on your investment. Therefore, a great investment does not likely have a high price. The point of this question is that the price you pay for a stock does matter enormously; it is the most important factor in your return. Accordingly, doing your fundamental analysis (thoroughly) is of a great importance when making your investments.

When determining whether a company's stock is a good investment, fundamental analysis is a great toolbox to reach a conclusion. 

 

Are you curious about fundamental elements?
Check out Euroinvestor's "Finance glossary" which explains many fundamental elements in details.
Click here to see EuroInvestor's "Finance Glossary"

 

 

See more articles in  Euroinvestor's Stock School

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Comments

#1 | Thursday 13 Dec (08:09)
Very nice explanation on all the ratios. Fundamental investing is really about looking for the most efficient and wonderful companies for the long term investment. I had trouble understanding whether a ratio is good bad or ugly but money works for me really solved it with their fundamental analysis and color codes.
#2 | Friday 3 Jan (05:14)
It’s really a nice and helpful piece of information. I’m glad that you shared this helpful info with us. Please keep us informed like this. Thanks for sharing napa valley limo wine tours.
#3 | Wednesday 7 May (11:28)
We all know that fundamental analysis is the cornerstone of investing. There are an endless number of investment strategies that are different from each other, yet almost all use the fundamentals. Thanks a lot for sharing this valuable info about fundamental analysis.
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#4 | Friday 19 Dec (08:52)
Thank you for clarifying about 5 Important Elements in Fundamental Analysis. I think this is very good and also beneficial, especially for business people. aidasafira , aidasafira , aidamotor , topmotor

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