An Introduction to Fundamental Analysis

Jason OBryan 19 September 2006

What is Fundamental Analysis?

A method of valuing a security by measuring its intrinsic value.

Economic Factors Financial Statements Industry Conditions

Quantitative

and Qualitative Factors

Quantitative
Analyzes key ratios. Provides concrete data

for analysis.

Qualitative
Analyzes intangible data. Patents, management, talented Difficult

workers, etc.

to measure numerically.

Why use fundamental analysis?

The goal is to produce a value that investors can compare with the current price. If it is undervalued you should buy; sell if it is overvalued. One of the most famous users of fundamental analysis, Warren Buffett, has successfully used this method to turn himself into a billionaire.

Ratios
Quick

Ratio Debt to Equity EPS Revenues P/E Beta

Current
ROE ROA PEG Alpha

Ratio

Net

Profit Margin

Revenues

Money that a company collects from customers for the sale of a product or service. When you subtract out all costs from revenues, you get profits or earnings.

Market Capitalization

The total dollar value of all outstanding shares, calculated by multiplying the price of a single share by the total number of shares outstanding.
1. 2. 3. 4. 5. 6.

Mega Cap: Market cap of $200 billion and greater Big/Large Cap: $10-$200 billion Mid Cap: $2 billion to $10 billion Small Cap: $300 million to $2 billion Micro Cap: $50 million to $300 million Nano Cap: Under $50 million

Net Profit Margin

Net income as a percentage of sales. You get this by dividing net income by sales. Since it's a percentage, it tells you how many cents on each dollar of sales is pure profit. The higher a companys profit margin compared to its competitors, the better.

Earnings Per Share (EPS)

A very important fundamental, calculated:

Basically, this will tell you if and how profitable the company is. Whats preferred stock?
A

class of ownership in a corporation with a stated dividend that must be paid before dividends to common stock holders.

Price/Earnings Ratio (P/E)

One of the favorite ratios, it is simply:

EPS from the last four quarters is called trailing P/E EPS taken from the estimates of earnings expected in the next four quarters is called forward P/E P/E is referred to as the "multiple," because it shows how much investors are willing to pay per dollar of earnings. High P/E means high projected earnings in the future.

It's usually only useful to compare the P/E ratios of companies in the same industry, or to the market in general, or against the company's own historical P/E

Price-to-Sales
Price to sales is calculated by dividing a stock's current price by its revenue per share. The price-to-sales ratio can vary substantially across industries; therefore, it's useful mainly when comparing similar companies. Also, it does not account for DEBT!

Price-to-Book
Price to book is calculated by dividing the current closing price of the stock by the latest quarter's book value (book value is simply total assets minus intangible assets and liabilities). A low P/B ratio could mean the stock is undervalued, or something is very wrong with the company.

Debt-to-Equity

A relative measure of how much debt a company has:

Essentially: long-term funds provided by creditors divided by funds provided by shareholders. A higher debt/equity ratio generally means that a company has been aggressive in financing its growth with debt. This can result in volatile earnings.

Current Ratio

A good measure of liquidity of a company, or how easily it can cough up cash. AKA - Indicator of company's ability to pay shortterm obligations; calculated by dividing current assets by current liabilities. The higher the ratio, the more liquid the company! What types of companies might this ratio be VERY important?

Quick Ratio

Like current ratio, this gives a measure of a companys financial strength:

It is a measure of how quickly a company's assets can be turned in cash. You subtract inventories so you can check and see if a company has sufficient liquid assets to meet short-term operating needs. (Note that current ratio did not subtract inventories.)

Return on Assets (ROA)

Also sometimes called Return on Investment or ROI, this is a measure what earnings were generated from capital investment back into the company.

Always given as a percentage Think of it as How much money (income) was generated from a companys investment into itself (capital investment or company assets)?

Return on Equity (ROE)

It is a measure of how much in earnings a company generates in four quarters compared to its shareholders' equity and is a good measure of profitability. It is also measured as a percentage. For instance, if XYZ Corp. made $1 million in the past year and has shareholders' equity of $10 million, then the ROE is 10%. Some use ROE as a screen to find companies that can generate large profits with little shareholder investment in the company.

Beta ()

A measure of a security's or portfolio's volatility, or systematic risk, in comparison to the market as a whole. (usually calculated with S&P 500 Index) Think of beta as the tendency of a security's returns to respond to swings in the market. A beta of 1 indicates that the security's price will move EXACTLY with the market. A beta less than 1 means that the security will be LESS volatile than the market. A beta greater than 1 indicates that the security's price will be MORE volatile than the market.

Price/Earnings to Growth (PEG)

It is: Can give you an idea of a stock potential growth, since it divides by Earnings Per Share (EPS) annual growth rate but is based on analysts ESTIMATES! If a company has a P/E of 20 and analysts expect its earnings will grow 15% annually over the next few years, you'd say it has a PEG of 1.33. Anything above 1 is suspect since that means the company is trading at a premium to its growth rate.

Others
There are many other ratios out there to help you get an idea of what the financial health of a company is. What do you do if you dont know what they mean?

Example vs.

Industry Comparison

Which is better?
Compare significant ratios and statistics. Read current news and annual reports to see what their plans are in the future. Look for historical growth and continued opportunity for growth.

Questions?