Here’s another in a series of posts to help introduce the novice to the basics of investing in the Stock market. If you are an experienced Investor or have knowledge of the markets then this post is probably not for you. You may want to read another one of my posts (hint!) instead. Another warning is that since the topic of this post is technical in nature, the reading will be somewhat, well….dry. If you’ve read my “about” page you’ll be fairly warned about my writing style. You’ll find that the more technical the material, the dryer the reading. Hopefully, as I gain experience in writing for my posts I’ll be able to capture everyone’s rapt attention with terms like “return on Assets”, make folks weep in gratitude when they see ” Gross Profit Margin” and laugh uncontrollably at reading “Earnings per Share”. But alas, my skills aren’t up to that kind of prose.
So, what is fundamental analysis? Fundamental Analysis of a stock involves studying financial results of a company and interpreting those results into an understandable number usually expressed as a ratio or a percentage. this post is intended to introduce the uninitiated to some basic terms they should be familiar with if they are considering a foray into stock investing. These are some of the more basic terms that you can expect to come across as you investigate stocks and consider whether they are a good investment for you.
P/E Ratio Price to earnings ratio = Share Price / Earnings per share P/E is a ratio that expresses the current price of the stock relative to its earnings. It’s one of the most common ratios used in the market. As a general rule, the lower the P/E the better the potential value a stock represents. If a company has a very high P/E that is usually an indicator that investors expect higher earnings growth in the future. Fair warning, if a company has a significantly low P/E that would ordinarily reflect that it is potentially a good buy. However, that may also be a signal that there are other things wrong with the company. Enron’s P/E probably looked pretty attractive at some point during its catastrophic decline
P/S Ratio – Price to Sales Ratio = Share Price / Revenue per Share
A ratio showing the current price relative to it’s revenue per share. This is similar to P/E with the exception that it’s comparing the share price to what the company actually earns on a per share basis.
P/B Ratio Price to Book = Share Price/Total Assets-Intangible assets and liabilities
Price to book is exactly what it sounds like. It is a ratio comparing the price of a stock to the worth of its underlying assets. One way of looking at it is what would be the intrinsic value of a share of stock if a company were to implode and dissolve itself. Not exactly a cheerful thought but it’s a useful number to look at. I tend to give this some level of importance when evaluating a company. If it’s low it could mean that a company is undervalued. But it could also mean that the company is in trouble and investors are simply fleeing from it.
ROA – Return on Assets = Net Income/Total Assets
ROA reflects how profitable a company is relative to it’s overall assets. You really want this indicator to be higher that or on par with the industry it’s in.
ROE – Return on Equity – Net Income/Shareholder Equity
ROE reflects how much return a stock delivers relative to the stockholders equity. I prefer this measure since it reflects a firms assets LESS it’s liabilities which is in effect how much a share of stock is truly worth.
Gross Profit Margin = (revenue-Cost of Goods Sold)/Revenue
Gross profit margin is usually expressed as a percentage. Obviously the higher the better but what constitutes an acceptable gross profit margin varies by Industry. Everything is relative and I believe a good baseline to compare any particular metric against is the industry average for the industry that the company you are researching happens to be in.
Operating Profit Margin = Operating Income/Net Sales
Operating Income is the income that is leftover after paying for Variable costs such as wages, raw material etc. Companies need a good operating margin to pay for their fixed costs. I generally don’t look at this metric other than to make sure that it is in positive territory.
Net Profit Margin = Net income/revenues
A measurement of what percentage of each dollar in earnings a company keeps after expenses. This is another one that I look at and expect to be in positive territory.
EPS and EPS Growth = (Net Income-Dividends on Preferred Stock)/shres outstanding
EPS tells you how much of the company’s earnings is allocated to each individual share of stock. This metric is used to calculate the P/ ratio. At the risk of stating the obvious, you want this to be high relative to the stock’s price. EPS growth reflects how a company has been performing in terms of revenue growth. Growth is usually expressed in one of two ways. TTM, which stands for trailing twelve months, shows you the growth rate of earnings for last twelve months and the metric should change on a monthly basis. MRQ is another way that a metric may be expressed. MRQ stands for “Most Recent Quarter” and is a narrower view in terms of the time frame being looked at. MY preference is to look at TTM. Quarters can vary widely, there are industries where poor quarters are the norm and events within a company can unfairly and negatively impact an MRQ measurement.
Revenue Growth – This is another metric that is pretty self-explanatory, you want to look at a company’s revenue growth over a longer period of time. If a company exhibits strong growth over time then in my mind, it’s a good candidate for further evaluation. If there’s declining growth then something may be wrong with the company or the industry it’s in and becomes a less likely candidate for my portfolio.
Quick Ratio (acid test) = (current assets-inventories)/current liabilities
The quick ratio, also called the acid test measures a company’s ability to pay it’s short term liabilities with its most liquid assets. It’s an important and quick way to understand what a company’s liquidity and financial health is. You want this metric to be high.
Debt to Total Capital = Debt/Shareholders Equity + Debt
You don’t see this metric mentioned very often but it is an important one to consider when evaluating a stock. Companies can finance their operations through debt or through equity. It’s preferable that they fund themselves with equity as much as possible although at times, some debt may be essential. Debt to Total capital gives you the ratio of how much debt, relative to a company’s equity the company has. You want this metric to be low, the higher this metric is, the more debt a company is taking on to fund its operations.
One important consideration when analyzing the basic measurements of a company is that you should be comparing the metrics against something. My preference is to compare these metrics against the industry average for whatever industry the company happens to be participating in. Although I don’t generally do this, it’s also ok to compare a metric against another company when you are trying to make a decision on which one fits your investment criteria better. Just make sure that both companies are in the same sector or industry. Many of these metrics can vary wildly between different industries. Trying to compare two companies against each other that are in different industries by basic fundamental analysis would be like trying to compare an apple and a coconut. They’re both fruit but that’s about all they have in Common.