Investors looking for hot stocks aren’t the only ones trolling the markets. A quiet group of folks called value investors go about their business looking for companies that the market has passed by.
Some of these investors become quite wealthy finding sleepers, holding on to them for the long term as the companies go about their business without much attention from the market, until one day they pop up on the screen, and some analyst “discovers” them and bids up the stock. Meanwhile, the value investor pockets a hefty profit.
Value investors look for some other indicators besides earnings growth and so on. One of the metrics they look for is the Price to Book ratio or P/B. This measurement looks at the value the market places on the book value of the company.
You calculate the P/B by taking the current price per share and dividing by the book value per share.
P/B = Share Price / Book Value Per Share
Like the P/E, the lower the P/B, the better the value. Value investors would use a low P/B is stock screens, for instance, to identify potential candidates. (By Ken Little)
If there is one number that people look at than more any other it is the Price to Earnings Ratio (P/E). The P/E is one of those numbers that investors throw around with great authority as if it told the whole story. Of course, it doesn’t tell the whole story (if it did, we wouldn’t need all the other numbers.)
The P/E looks at the relationship between the stock price and the company’s earnings. The P/E is the most popular metric of stock analysis, although it is far from the only one you should consider.
You calculate the P/E by taking the share price and dividing it by the company’s EPS.
P/E = Stock Price / EPS
For example, a company with a share price of $40 and an EPS of 8 would have a P/E of 5 ($40 / 8 = 5).
What does P/E tell you? The P/E gives you an idea of what the market is willing to pay for the company’s earnings. The higher the P/E the more the market is willing to pay for the company’s earnings. Some investors read a high P/E as an overpriced stock and that may be the case, however it can also indicate the market has high hopes for this stock’s future and has bid up the price.
Conversely, a low P/E may indicate a “vote of no confidence” by the market or it could mean this is a sleeper that the market has overlooked. Known as value stocks, many investors made their fortunes spotting these “diamonds in the rough” before the rest of the market discovered their true worth.
What is the “right” P/E? There is no correct answer to this question, because part of the answer depends on your willingness to pay for earnings. The more you are willing to pay, which means you believe the company has good long term prospects over and above its current position, the higher the “right” P/E is for that particular stock in your decision-making process. (By Ken Little)
There are three ways to look at price to earnings ratios, or P/E ratios. You can look at P/E ratios based on last year’s earnings, forecasted earnings, or a ten year average of earnings.
1. P/E Ratio Based On Last Year’s Earnings
This calculation takes current price of the market divided by last year’s corporate earnings. The problem with relying on this calculation is the possibility that next year will be nothing like last year; corporate earnings could me much higher, or much lower.
2. P/E Ratio Based On Forecasted Earnings
This calculation takes the current price of the market divided by an average of all of the forecasted earnings put forth by analysts and the companies themselves. The problem with this calculation is there are numerous occasions where forecasted earnings are not accurate.
That is what makes the market so difficult to evaluate. No one truly knows what will happen next year. A lot of smart people make forecasts; some will be right and some will be wrong.
3. P/E Ratio Based On A Ten Year Average Of Earnings
This calculation takes the current price of the market divided by corporate earnings as averaged over the past ten years. This ratio is called P/E 10 and the method was developed by Professor Robert Schilling. It is designed to even out the inconsistencies that can come from using only one year of past or projected earnings data. (By Dana Anspach)
The P/E is the most popular way to compare the relative value of stocks based on earnings because you calculate it by taking the current price of the stock and divide it by the Earnings Per Share (EPS). This tells you whether a stock’s price is high or low relative to its earnings.
Some investors may consider a company with a high P/E overpriced and they may be correct. A high P/E may be a signal that traders have pushed a stock’s price beyond the point where any reasonable near term growth is probable.
However, a high P/E may also be a strong vote of confidence that the company still has strong growth prospects in the future, which should mean an even higher stock price.
Because the market is usually more concerned about the future than the present, it is always looking for some way to project out. Another ratio you can use will help you look at future earnings growth is called the PEG ratio. The PEG factors in projected earnings growth rates to the P/E for another number to remember.
You calculate the PEG by taking the P/E and dividing it by the projected growth in earnings.
PEG = P/E / (projected growth in earnings)
For example, a stock with a P/E of 30 and projected earning growth next year of 15% would have a PEG of 2 (30 / 15 = 2).
What does the “2” mean? Like all ratios, it simply shows you a relationship. In this case, the lower the number the less you pay for each unit of future earnings growth. So even a stock with a high P/E, but high projected earning growth may be a good value.
Looking at the opposite situation; a low P/E stock with low or no projected earnings growth, you see that what looks like a value may not work out that way. For example, a stock with a P/E of 8 and flat earnings growth equals a PEG of 8. This could prove to be an expensive investment.
A few important things to remember about PEG:
- It is about year-to-year earnings growth
- It relies on projections, which may not always be accurate (By Ken Little)
f you give some management teams a couple of boards, some glue, and a ball of string, they can build a profitable growing business, while other teams can’t make a profit with several billion dollars worth of assets.
Return on Equity (ROE) is one measure of how efficiently a company uses its assets to produce earnings. You calculate ROE by dividing Net Income by Book Value. A healthy company may produce an ROE in the 13% to 15% range. Like all metrics, compare companies in the same industry to get a better picture.
While ROE is a useful measure, it does have some flaws that can give you a false picture, so never rely on it alone. For example, if a company carries a large debt and raises funds through borrowing rather than issuing stock it will reduce its book value. A lower book value means you’re dividing by a smaller number so the ROE is artificially higher. There are other situations such as taking write-downs, stock buy backs, or any other accounting slight of hand that reduces book value, which will produce a higher ROE without improving profits.
It may also be more meaningful to look at the ROE over a period of the past five years, rather than one year to average out any abnormal numbers.
Given that you must look at the total picture, ROE is a useful tool in identifying companies with a competitive advantage. All other things roughly equal, the company that can consistently squeeze out more profits with their assets, will be a better investment in the long run. (By Ken Little)
There are some metrics used in fundamental analysis that fall into what I call the “ho-hum” category.
The Dividend Payout Ratio (DPR) is one of those numbers. It almost seems like a measurement invented because it looked like it was important, but nobody can really agree on why.
The DPR (it usually doesn’t even warrant a capitalized abbreviation) measures what a company’s pays out to investors in the form of dividends.
You calculate the DPR by dividing the annual dividends per share by the Earnings Per Share.
DPR = Dividends Per Share / EPS
For example, if a company paid out $1 per share in annual dividends and had $3 in EPS, the DPR would be 33%. ($1 / $3 = 33%)
The real question is whether 33% is good or bad and that is subject to interpretation. Growing companies will typically retain more profits to fund growth and pay lower or no dividends.
Companies that pay higher dividends may be in mature industries where there is little room for growth and paying higher dividends is the best use of profits (utilities used to fall into this group, although in recent years many of them have been diversifying).
Either way, you must view the whole DPR issue in the context of the company and its industry. By itself, it tells you very little. (By Ken Little)
How much is a company worth and is that value reflected in the stock price?
There are several ways to define a company’s worth or value. One of the ways you define value is market cap or how much money would you need to buy every single share of stock at the current price.
Another way to determine a company’s value is to go to the balance statement and look at the Book Value. The Book Value is simply the company’s assets minus its liabilities.
Book Value = Assets - Liabilities
In other words, if you wanted to close the doors, how much would be left after you settled all the outstanding obligations and sold off all the assets.
A company that is a viable growing business will always be worth more than its book value for its ability to generate earnings and growth.
Book value appeals more to value investors who look at the relationship to the stock's price by using the Price to Book ratio.
To compare companies, you should convert to book value per share, which is simply the book value divided by outstanding shares. (By Ken Little)
Not all of the tools of fundamental analysis work for every investor on every stock. If you are looking for high growth technology stocks, they are unlikely to turn up in any stock screens you run looking for dividend paying characteristics.
However, if you are a value investor or looking for dividend income then there are a couple of measurements that are specific to you. For dividend investors, one of the telling metrics is Dividend Yield.
This measurement tells you what percentage return a company pays out to shareholders in the form of dividends. Older, well-established companies tend to payout a higher percentage then do younger companies and their dividend history can be more consistent.
You calculate the Dividend Yield by taking the annual dividend per share and divide by the stock’s price.
Dividend Yield = annual dividend per share / stock's price per share
For example, if a company’s annual dividend is $1.50 and the stock trades at $25, the Dividend Yield is 6%. ($1.50 / $25 = 0.06) (By Ken Little)
You have a number of tools available to you when it comes to evaluating companies with earnings. The first three articles listed at the bottom of this article, in particular deal with earnings directly. You can add the two others on dividends and the one on return on equity to the list as specific to companies that are or have made money in the past.
Does that mean companies that don’t have any earnings are bad investments? Not necessarily, but you should approach companies with no history of actually making money with caution.
The Internet boom of the late 1990s was a classic example of hundreds of companies coming to the market with no history of earning – some of them didn’t even have products yet. Fortunately, that’s behind us.
However, we still have the problem of needing some measure of young companies with no earnings, yet worthy of consideration. After all, Microsoft had no earnings at one point in its corporate life.
One ratio you can use is Price to Sales or P/S ratio. This metric looks at the current stock price relative to the total sales per share. You calculate the P/S by dividing the market cap of the stock by the total revenues of the company.
You can also calculate the P/S by dividing the current stock price by the sales per share.
P/S = Market Cap / Revenues
or
P/S = Stock Price / Sales Price Per Share
Much like P/E, the P/S number reflects the value placed on sales by the market. The lower the P/S, the better the value, at least that’s the conventional wisdom. However, this is definitely not a number you want to use in isolation. When dealing with a young company, there are many questions to answer and the P/S supplies just one answer. (By Ken Little)
One of the challenges of evaluating stocks is establishing an “apples to apples” comparison. What I mean by this is setting up a comparison that is meaningful so that the results help you make an investment decision.
Comparing the price of two stocks is meaningless as I point out in my article “Why Per-Share Price is Not Important.”
Similarly, comparing the earnings of one company to another really doesn’t make any sense, if you think about it. Using the raw numbers ignores the fact that the two companies undoubtedly have a different number of outstanding shares.
For example, companies A and B both earn $100, but company A has 10 shares outstanding, while company B has 50 shares outstanding. Which company’s stock do you want to own?
It makes more sense to look at earnings per share (EPS) for use as a comparison tool. You calculate earnings per share by taking the net earnings and divide by the outstanding shares.
EPS = Net Earnings / Outstanding Shares
Using our example above, Company A had earnings of $100 and 10 shares outstanding, which equals an EPS of 10 ($100 / 10 = 10). Company B had earnings of $100 and 50 shares outstanding, which equals an EPS of 2 ($100 / 50 = 2).
So, you should go buy Company A with an EPS of 10, right? Maybe, but not just on the basis of its EPS. The EPS is helpful in comparing one company to another, assuming they are in the same industry, but it doesn’t tell you whether it’s a good stock to buy or what the market thinks of it. For that information, we need to look at some ratios.
Before we move on, you should note that there are three types of EPS numbers:
- Trailing EPS – last year’s numbers and the only actual EPS
- Current EPS – this year’s numbers, which are still projections
- Forward EPS – future numbers, which are obviously projections (By Ken Little)
Fundamental Analysis Techniques
Efficiency Ratios
IF ONE GROUP of managers was able to squeeze more money out its assets or capital than another, you'd go with the first one, right? Of course. That's why accountants and stock analysts long ago began looking for a reliable way to measure management efficiency. Return on equity (ROE) and return on assets (ROA) are what they came up with.
Both ratios are an effort to measure how much earnings a company extracts from its resources. Return on equity is calculated by taking income (before any non-recurring items) and dividing it by the company's common equity or book value. Expressed as a percentage, it tells you what return the company is making on the equity capital it has deployed. Return on assets is income divided by total assets. It gives you a sense of how much the company makes from all the assets it has on the books -- from its factories to its inventories.
As measures of pure efficiency, these ratios aren't particularly accurate. For one thing (as we've mentioned repeatedly), earnings can be manipulated. It's also true that the asset values expressed on balance sheets are (for various reasons) not entirely reflective of what a company is really worth. Microsoft or an investment bank like Goldman Sachs, as they say, rely on thousands of intellectual assets that walk out the front door every day.
But ROE and ROA are still effective tools for comparing stocks. Since all
Fundamental Analysis Techniques
Margins
LIKE ROE and ROA, calculating a company's margins is a way of getting at management efficiency. But instead of measuring how much managers earn from assets or capital employed, this ratio measures how much a company squeezes from its total revenue (sales).
Sounds a lot like earnings, right? Well, margins are really just earnings expressed as a ratio -- a percentage of sales. The advantage is that a percentage can be used to compare the profitability of different companies while an absolute number cannot. An example should help. In the spring of 1999, Sears had net income of about $1.1 billion on annual sales of about $41.2 billion. Wal-Mart, meanwhile, was earning about $4.7 billion on sales of $143 billion. Comparing $4.7 billion with $1.1 billion wouldn't tell you much about which company was more efficient. But if you divide the earnings by the sales, you'll see that Wal-Mart was returning 3.3% on sales while Sears was returning just 2.7%. The difference doesn't sound like much but it was worth about $839 million to Wal-Mart shareholders. And it's one of the reasons Wal-Mart was trading at about twice the multiple of Sears.
Analysts look at various types of margins -- gross, operating, pretax or net. Each uses an earnings number that is further down the Income Statement (see Price/Cash Flow for more on how the Income Statement works). What's the difference? As you move down the statement, different types of expenses are factored in. The various margin calculations let you refine what you're looking at.
- Gross margins show what a company earns after all the costs of producing what it sells are factored in. That leaves out a lot -- marketing expenses, administrative costs, taxes, etc. -- but it tells you how profitable the basic business is. Consider that Wal-Mart's gross margin was about 22% in the spring of '99. Sears' was 34%.
- Operating margins figure in those selling and administrative costs, which for most companies are a large and important part of doing business. But they come before interest expenses on debt and the noncash cost of depreciation on equipment. The earnings number used in this ratio is sometimes called cash flow or earnings before interest, taxes, depreciation and amortization (EBITDA). It measures how much cash the business throws off and some consider it a more reliable measure of profitability since it is harder to manipulate than net earnings.
- Pretax margins take into account all noncash depreciation on equipment and buildings, as well as the cost of financing debt. But they come before taxes and they don't include one-time (so called "extraordinary") expenses like the cost of shutting a factory or writing off some other investment.
- Net margins measure the bottom line -- profitability after all expenses. This is what shareholders collect (theoretically) and so closely watch.
Margins are particularly helpful since they can be used both to compare profitability among many companies (as we demonstrated with Wal-Mart and Sears above) and to look for financial trouble at a single outfit. Viewing how a company's margins grow or shrink over time can tell you a lot about how its fortunes are changing. Between early 1995 and January of 1999, for instance, Dell Computer's net margin doubled from 4.3% to 8% even as the cost of a PC declined markedly. What does that tell you? Dell was driving down prices and manufacturing more efficiently. Rival Compaq Computer, meanwhile, went disastrously in the opposite direction -- 8% to -8% -- as the company ran into trouble digesting several acquisitions and began to lose money. That helps explain why Compaq's shares rose about 250% during that time while Dell's roared ahead almost 8,000%
Fundamental Analysis Techniques
Inventories
IF YOU ASKED the average company president what he (hey, don't blame us for the averages) thinks of inventory, he'd likely sigh and tell you it's a necessary evil. Manufacturers have warehouses filled with raw materials, component parts and finished goods to help fill orders. Retailers have stock waiting to be sold. For every moment any of it sits idle on the shelves, it costs the company money to store and finance. That's why managers strive with all they've got to have as little inventory on hand as possible.
Certain types of companies (manufacturers, retailers) by nature must carry more inventory than others (software makers, advertising companies). So as an investor you want to look for two things here: First, does one company in a given industry carry more inventory as a percentage of sales than its rivals? Second, are its inventory levels rising dramatically for some unexplained reason?
You can't look at inventory in isolation. After all, if a company's inventory level increased 20% but sales grew at a rate of 30%, then the increase in inventory should be expected. The warning sign is if inventory spikes despite normal growth in sales. In 1997, for instance, the stock of high-flying apparel maker Tommy Hilfiger got nailed when its inventories suddenly rose 50% spooking Wall Street analysts, who figured the popular men's wear maker had lost its edge among teenage boys. Tommy eventually righted the situation (it had more to do with inventory management than fashion sense) and the stock recovered. But a lot of investors lost money along the way.
A helpful number to look at is the inventory-turnover ratio. It's annual sales divided by inventory and it reflects the number of times inventory is used and replaced throughout a year. Low inventory turnover is a sign of inefficient inventory management. For example, if a company had $20 million in sales last year but $60 million in inventory, then inventory turnover would be 0.3, an unusually low number. That means it would take three years to sell all the inventory. That's obviously not good.
There's no rule of thumb when it comes to turnover. It's best to make comparisons. If a retailer had a turnover of 4, for example, and its closest competitor had turnover of 6, it would indicate that the company with higher turnover is more efficient and less likely to get caught with a lot of unsold goods.
Fundamental Analysis Techniques
Current Assets/Liabilities
These statistics are always worth a look to take a company's short-term temperature. Current assets are things like cash and cash equivalents, accounts receivable (money owed the company by customers) and inventories. They are defined as anything that could be sold quickly to raise money. Current liabilities are what the company owes in short order -- mostly accounts payable and short-term debt.
The thing to look for here is a big change from period to period. If the current assets number grows quickly, it could mean the company is accumulating cash -- a good thing. Or it is having trouble collecting accounts receivable from customers -- a bad thing. Precipitous growth in current liabilities is rarely a good thing, but it might be explainable due to some short-term corporate goal.
If you see a spike in either category, it's worth further explanation. Check the analyst research, news reports or get the financial statements and read the notes. Management is required to explain changes in the company's financial condition.
Fundamental Analysis Techniques
Beta
HOW MUCH volatility can you expect from a given stock? That's well worth knowing if you want to avoid being shocked into panic selling after buying it. Some stocks trend upward with all the consistency of a firefly. Others are much more steady. Beta is what academics call the calculation used to quantify that volatility.
The beta figure compares the stock's volatility to that of the S&P 500 index using the returns over the past five years. If a stock has a beta of 1, for instance, it means that over the past 60 months its price has gained 10% every time the S&P 500 has moved up 10%. It has also declined 10% on average when the S&P declines the same amount. In other words, the price tends to move in synch with the S&P, and it is considered a relatively steady stock.
The more risky a stock is, the more its beta moves upward. A figure of 2.5 means a gain or loss of 25% every time the S&P gains or loses just 10%. Likewise, a beta of 0.7 means the stock moves just 7% when the index moves in either direction. A low-beta stock will protect you in a general downturn, a high Beta means the potential for outsize rewards in an upturn.
That's how it is supposed to work, anyway. Unfortunately, past behavior offers no guarantees about the future. If a company's prospects change for better or worse, then its beta is likely change, too. So use the figure as a guide to a stock's tendencies, not as a crystal ball.
