Investors come in all shapes and forms, so to speak, but there are two basic types. The first and most common are the more conservative types, who will choose stocks by looking at and researching the underlying value of a company. This belief is based on the assumption that as long as the company does well and continues to make profits, the stock price will rise. These investors try to buy stocks that are growing, stocks that are likely to continue growing in the long term.
The second but less common type of investor tries to predict how the market may behave based purely on the psychology of market participants and other similar market factors. This second type of investor is more often called “Quant”. These investors assume that the stock price will soar as buyers keep bidding back and forth (often regardless of the value of the stock), much like an auction. They often take a much higher risk with a higher potential return—but with a much higher potential loss if they fail.
To find out the inherent value of a stock, investors must consider many factors. When the stock price is consistent with its value, it will achieve the goal of an “efficient” target market. Efficient market theory states that stock prices are always correct because everything the public knows about a stock is reflected in its market price. This theory also implies that analyzing stocks is pointless because all currently known information is reflected in the current price. To make it simpler:
The stock market sets prices.
The analyst weighs the known information about the company and thus determines its value.
Price does not have to equal value. The efficient market theory is as the name suggests, a theory. If it’s legal, the price will instantly adapt to the available information. Since this is a theory, not a law, this is not the case. Stock prices move above and below the firm’s value for both rational and irrational reasons.
Fundamental Analysis seeks to ascertain the future value of a stock by means of analyzing the current and/or past financial strength of a particular company. Analysts seek to determine whether the stock price is above or below value and what that means for the future of the stock. There are many factors used for this purpose. Basic terminology that helps investors understand analyst determinations includes:
“Value Stocks” are those that are below market value, and include low-cost stocks that are listed at 50 cents per dollar.
“Growth Stocks” are those with revenue growth as a primary consideration.
“Revenue Share” is an investment that provides a steady source of income. This is mainly through dividends, but bonds are also a common investment tool used to generate income.
“Momentum stocks” are new companies that are currently entering the market picture. Their share price increased rapidly.
To make sound fundamental decisions, all of the following factors must be considered. The preceding terminology will be the underlying determining factor in how each will be used, based on investor bias.
1. As always, the revenue of a particular company is the main determining factor. The company’s profit is profit after taxes and fees. The stock and bond markets are primarily driven by two strong dynamisms: earnings and interest rates. Intense competition often accompanies the flow of money into these markets, moving into bonds when interest rates rise and into stocks when earnings rise. More than any other factor, the company’s revenue creates value, although other suggestions should be considered with this idea.
2. EPS (Earning Per Share) is defined as the amount of reported earnings per share, which the company has at any given time to pay dividends to common stockholders or to reinvest itself. This indicator of the company’s condition is a very powerful way to predict future stock prices. Earning Per Share is arguably one of the most widely used fundamental ratios.
3. The fair price of a share 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, it has a P/E of 10, which means investors can expect a 10% cash flow return.
Equation: $6/$60 = 1/10 = 1/(PE) = 0.10 = 10%
Correspondingly, if it earns $3 per share, it has a multiple of 20. In this case, the investor can receive a 5% return, as long as current conditions remain the same in the future.
Example: $3/$60 = 1/20 = 1/(P/E) = 0.05 = 5%
Certain industries have different P/E ratios. For example, banks have low P/E, usually in the 5 to 12 range. In contrast, high-tech companies have higher P/E ratios, generally around 15 to 30. On the other hand, not so long ago. , the triple-digit P/E ratio for internet stocks is visible. These are stocks with no earnings but high P/E ratios, defying market efficiency theory.
A low P/E is not a true indication of an exact value. Price volatility, range, direction, and important news about a stock should be considered first. Investors should also consider why the given P/E is low. P/E is best used to compare companies from similar industries.
Beardstown Ladies recommends that any P/E lower than 5 and/or above 35 be carefully examined for errors, as the market average has historically been between 5 and 20.
Peter Lynch suggests comparing the P/E ratio with the company’s growth rate. Lynch considers stock prices fair only if they are about the same. If it’s less than the growth rate, it could be a stock bargain. To put this into perspective, the basic belief is that a P/E ratio of half the growth rate is very positive, and a ratio that doubles the growth rate is very negative.
Other research shows that a stock’s P/E ratio has little effect on the decision to buy or sell a stock (William J. O’Neal, founder of Investors Business Daily, in his study of successful stock movements). He said the stock’s current record earnings and annual earnings gains were, however, critical.
It is worth mentioning that the value represented by P/E and/or Earnings per Share is not useful to investors prior to the purchase of shares. Money is made after shares are purchased, not before. Therefore, it is the future that will pay, both in the form of dividends and growth. This means that investors need to pay as much attention to forecasting future earnings as they do to historical records.
4. PSR (Price/Sales Ratio) Basically similar to the P/E ratio, except the share price is divided by sales per share as opposed to earnings per share.
For many analysts, PSR is a better indicator of value than P/E. This is because revenue often fluctuates wildly, while sales tend to follow trends more reliably.
PSR can also be a more accurate measure of value because sales are more difficult to manipulate than revenue. The credibility of financial institutions has suffered through the Enron/Global Crossing/WorldCom, et al, disasters, and investors have learned how manipulation occurs in large financial institutions.
PSR by itself is not very effective. It is effectively used only in conjunction with other measures. James O’Shaughnessy, in his book What Works on Wall Street, finds that, when PSR is used as a measure of relative strength, PSR becomes the “King of value factors.”
5. Debt Ratio shows the percentage of debt owned by the company compared to shareholder equity. In other words, how much the company’s operations are financed by debt.
Remember, below 30% is positive, above 50% is negative.
Successful operations with increased profitability and well-marketed products can be crushed by the company’s debt burden, as revenue is sacrificed to offset debt.
6. ROE (Equity Returns) is obtained by dividing net income (after tax) by owner’s equity.
ROE is often considered the most important financial ratio (for shareholders) and the best measure of the company’s management ability. ROE gives shareholders the confidence they need to know that their money is being managed properly.
ROE must always increase every year.
7. Price/Book Value Ratio (aka Market/Book Ratio) compares the market price with the book value per share. This ratio relates what investors believe is the value of the company (shares) with what the company’s accountants say in accordance with recognized accounting principles. For example, a low ratio would indicate that investors believe that the company’s assets have been overvalued based on its financial statements.
While investors want stocks to trade at the same point as book value, in reality, most stocks trade above book value or at a discount.
Trading stocks at 1.5 to 2 times book value is about the limit when looking for stock values. Stock growth justifies higher ratios, as they provide higher anticipated earnings. The ideal is a stock below book value, at wholesale prices, but this is rare. Companies with low book values are often the target of takeovers, and are usually avoided by investors (at least until the takeover is complete and the process begins again).
Book value is more important at a time when most industrial firms have actual hard assets, such as factories, to support their inventories. Unfortunately, the value of this measure has diminished as low-cap companies have become commercial giants (i.e. Microsoft). Videolicet, look for low book values to keep the data in perspective.
8. Beta compares the volatility of the stock with the market. Beta 1 proposes that stock prices move up and down at the same rate as the market as a whole. Beta 2 means that when the market goes down, the stock will likely move at twice that amount. Beta 0 means not moving at all. Negative beta means it moves in the opposite direction of the market, causing a loss for investors.
9. Capitalization is the total value of all outstanding shares of a company, and is calculated by multiplying the market price per share by the total number of shares outstanding.
10. Institutional Ownership refers to the percentage of outstanding shares of a company owned by institutions, mutual funds, insurance companies, etc., that move in and out of positions within very large blocks. Some institutional holdings can actually provide a measure of stability and contribute to the roll with their buying and selling, respectively.
Investors consider this an important factor as they can take advantage of the extensive research carried out by these institutions before making their own portfolio decisions. The importance of institutions in market action cannot be overstated, and they account for more than 70% of the volume of dollars traded daily.
Market efficiency is the goal of the market at all times. Anyone who invests money in stocks wants to see a return on their investment. However, as mentioned earlier, human emotions will always move the market, causing the value of common stock to be too high and low.
Investors should take advantage of patterns using modern computing tools to find the most undervalued stocks as well as develop the correct response to these market patterns, such as rolling in a channel (recognizing trends) with intelligence.