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Stock Market – How to Use Fundamental Analysis to Make Trading Decisions
Investors come in many shapes and forms, so to speak, but there are two basic types. The first and most common is the more conservative type, who will choose stocks by looking at and researching the company’s fundamental value. It is based on the assumption that as long as the company runs well and continues to turn a profit, the stock price will increase. These investors try to buy growth stocks, which look likely to grow over the long term.
A second but less common type of investor tries to predict how the market might behave based on the psychology of people in the market and other similar market factors. The second type of investor is usually called a “quant.” This investor predicts that the price of a stock will rise as buyers keep bidding (often regardless of the stock’s price), similar to an auction. They often take very high risks with very high potential returns – but with very high potential for high losses if they fail.
To find a stock’s underlying value, investors must consider several factors. When a stock’s price is consistent with its value, it reaches the target of an “efficient” market. The efficient market theory states that stocks are always correctly priced because everything that is publicly known about a stock is reflected in its market price. This theory also states that analyzing stocks is pointless as all known information is reflected in the current price. Simply put:
- The stock market determines the price.
- Analysts weigh known information about a company and thus determine a value.
- Price does not equal price. Effective market theory is, as the name suggests, a theory. If this is the law, prices will immediately adapt to the information when it becomes available. Because this is a theory rather than a law, this is not the case. Stock prices move up and down along with company values for rational and irrational reasons.
Fundamental analysis attempts to determine the future value of a stock by analyzing the current and/or past financial strength of a particular company. Analysts try to determine whether a stock’s value is above or below its value and what the future means for that stock. There are several factors used for this purpose. Basic terminology that helps investors understand analysts’ determinations:
- “Value stocks” are those that are below market value, and include bargain stocks listed at 50 cents per dollar of value.
- “Growth stocks” are those with earnings growth as the primary consideration.
- “Income stock” is an investment that provides a steady source of income. This is primarily through dividends, but bonds are also investment instruments used to generate income.
- “Momentum stocks” are growth companies currently entering the market picture. Their share price is increasing rapidly.
To make the right basic decisions, all the following factors should be considered. Based on previous terminology investor bias will be the basic determining factor of how each will be used.
1. In general, the income of a particular company is the main determining factor. A company’s income is profit after taxes and expenses. Stock and bond markets are primarily driven by two powerful dynamics: earnings and interest rates. Fierce competition often accompanies the flow of money into these markets, moving into bonds when interest rates rise and into stocks when incomes rise. More than any other factor, a company’s earnings create value, although other considerations should be considered with this consideration.
2. EPS (earnings per share) is defined as the amount of earnings per share, which a company has on hand at any given time to pay dividends to common shareholders or to reinvest in itself. This indicator of a company’s condition is a very powerful way of predicting the future of stock prices. Earnings per share is one of the most widely used basic ratios.
3. A stock’s fair value is also determined by the P/E (price/earnings) ratio. For example, if a particular company’s stock is trading at $60 and its EPS is $6 per share, its P/E is 10, meaning investors can expect a 10% cash flow return.
Equation: $6/$60 = 1/10 = 1/(PE) = 0.10 = 10%
Along these same lines, if it makes $3 a share, it has a multiple of 20. In this case, an investor can get a 5% return, as long as the current situation remains the same in the future.
Example: $3/$60 = 1/20 = 1/(P/E) = 0.05 = 5%
Some industries have different P/E ratios. For example, banks have a low P/E, usually in the range of 5 to 12. High technology companies have high P/E ratios, usually around 15 to 30. On the other hand, in the not too distant past, triple-digit P/E ratios were seen for Internet-stocks. These were stocks with no earnings but high P/E ratios, defying market efficiency principles.
A low P/E is not an accurate indication of true value. Price volatility, range, direction, and notable news regarding the stock should be considered first. Investors should also consider why any given P/E is low. P/E is best used to compare industry-similar companies.
The Beardstown Ladies Any P/E errors below 5 and/or above 35 suggest close scrutiny, as the market average has historically been between 5 and 20.
Peter Lynch It suggests comparing the P/E ratio with the company’s growth rate. Lynch considers stocks fair value if they are roughly equal. If it’s lower than the growth rate, it could be a stock bargain. To put this in perspective, the basic belief is that a P/E ratio that halves the growth rate is too positive, and one that doubles the growth rate is too negative.
Other studies suggest that a stock’s P/E ratio has little effect on the decision to buy or sell a stock (William J. O’Neill, founder of Investor Business Daily, in his study of successful stock moves). However, he says the stock’s current earnings record and year-over-year earnings growth are important.
It needs to be mentioned that the value represented by P/E and/or earnings per share is worthless to investors before buying a stock. Money is made after buying the stock, not before. Therefore, it is the future that will pay, both in dividends and growth. This means investors need to pay as much attention to future earnings projections as historical records.
4. The basic PSR (price/sales ratio) is similar to the P/E ratio, except that the stock price is divided by sales per share as opposed to earnings per share.
- For many analysts, PSR is a better value indicator than P/E. This is because earnings often fluctuate, while sales follow more reliable trends.
- PSR may also be a more accurate measure of value because sales are more difficult to manipulate than earnings. With the Enron/Global Crossing/WorldCom, et al, debacle, the credibility of financial institutions has been affected, and investors have learned how to manipulate large financial institutions.
- PSR itself is not very effective. It is used effectively only in conjunction with other measures. James O’Shaughnessy found in his book What Works on Wall Street that, when used with PSR as a measure of relative strength, it is “the king of price factors”.
5. The debt ratio shows the percentage of a company’s debt compared to shareholder equity. In other words, how much of the company’s operating debt is being spent.
- Remember, less than 30% is positive, more than 50% is negative.
- A successful operation with increasing profits and better marketing products can be destroyed by a company’s debt load, as income is sacrificed to offset debt.
6. ROE (return on equity) is found by dividing net income (after taxes) by owner’s equity.
- ROE is often considered the most important financial ratio (for stockholders) and the best measure of a company’s management capabilities. ROE gives stockholders the confidence they need to know their money is well managed.
- ROE should always increase on an annual basis.
7. The price/book value ratio (aka market/book ratio) compares the market price to the book value of a stock per share. This ratio relates to what investors believe the company (stock) is worth according to the company’s accountants, according to generally accepted accounting principles. For example, a low ratio suggests that investors believe the company’s assets are overvalued based on its financial statements.
While investors want stocks to trade at the same point as book value, in reality, most stocks trade either at a price above book value or at a discount.
Stocks trading at 1.5 to 2 times book value is about the limit when looking for value stocks. Growth stocks justify higher ratios, because they offer higher income prospects. Ideally stock would be below book value, at wholesale prices, but this rarely happens. Companies with low book value are often targets of takeovers, and are generally ignored by investors (at least until the acquisition is completed and the process starts anew).
Book value was more important at a time when most industrial companies had real hard assets, such as factories, to back up their stock. Unfortunately, the value of this measure has declined as undercapitalized companies have become commercial giants (i.e. Microsoft). Videlicet, look for a lower book value to put the data in perspective.
8. Beta compares a stock’s volatility to that of the market. A beta of 1 suggests that the stock price moves up and down at the same rate as the overall market. A beta of 2 means that the stock is likely to move twice that amount when the market falls. A beta of 0 means it doesn’t move at all. A negative beta means it moves in the opposite direction of the market, spelling losses for the investor.
9. Capitalization is the total value of all outstanding shares of a company, and is calculated by multiplying the market value per share by the total number of outstanding shares.
10. Institutional ownership refers to the percentage of a company’s outstanding shares owned by institutions, mutual funds, insurance companies, etc., which move in and out of positions in very large blocks. Some institutional ownership can actually provide a measure of stability and contribute to the roll with their purchases and sales respectively. Investors consider this an important factor because they can make use of the extensive research conducted by these institutions before making their portfolio decisions. The importance of institutions in market functioning cannot be overstated, and account for more than 70% of the dollar volume traded daily.
Market efficiency is always the market goal. Anyone who puts money into stocks wants to see a return on their investment. Still, as mentioned earlier, human emotions will always drive the market, causing common stocks to become overvalued and undervalued. Investors should take advantage of patterns using modern computing tools to find the stocks with the lowest value stocks as well as to develop the right reaction to these market patterns, such as rolling within the channel with intelligence (recognizing trends).
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