Fundamentals (Part 1)

By Zach VeencampStock Analysis

Fundamental Tools Explained

With the way the market has moved throughout the year & the unreliability seen amongst the biggest names of the past decade, I figured I’d start a series of posts to touch on some of the most common fundamental analysis tools that anyone can use to analyze the value of a stock’s current price.

Fundamental Analysis

Fundamental Analysis in a nutshell involves analyzing a company’s financial statements in order to assess the company’s financial health and makes it possible to compare a company’s financial position to that of their competitors and/or assess the sector ‘norms’, so to speak. It allows the individual to break down and compare a company’s assets, liabilities and earnings relative to other financial variables.

Some of the main goals of fundamental analysis:

  • Making financial forecasts based on trends
  • Assessing downside risk for a stock
  • Comparing companies’ financial positions
  • Valuing a stock relative to it’s financial variables
  • Analyzing a sector/market as a whole from a potential return standpoint

Lastly, the tools utilized in fundamental analysis can go beyond simply company analysis & can be used in Industry Analysis and Economic Analysis. To the latter, an individual can utilize the underlying concepts in fundamental ratios and tools in regards to Economic Analysis and analyze GDP Growth rates, Inflation forecasts, interest rate trends, exchange rate movements, productivity trends and energy pricing forecasts.

Fundamental Tools

The first ratio I wanted to touch on is the Price-to-Earnings Ratio (P/E Ratio): P/E= Stock’s Current Price ÷ Earnings Per Share

This seems to be the most common fundamental measure on a market-wide basis. In short, the P/E ratio is the price an investor pays for $1 of a company’s earnings. It’s a gauge of how much investors are willing to pay per dollar of a company’s earnings. An investor can utilize this P/E ratio to compare a specific company with its peers to evaluate if it’s relatively expensive or cheap. Additionally, one could analyze the P/E of a company over the past 4 quarters (or years) to compare their stock’s current price to the historical standard.

Forward P/E: Forecasts the company’s growth into the future. Forward P/E = Stock’s Current Price ÷ Next 4 Quarters Estimated EPS

Earnings per share is the companies Retained Earnings (remaining net income/loss after paying dividends) divided by the Outstanding Shares (number of shares out in the market at the time). In essence, this gives an investor an idea of how much of the remaining net income or loss can be attributed to the number of shares an investor owns. However, by no means is the company obligated to give their investors the attributable amount.  Retained Earnings = Beginning Retained Earnings + Net Income/Loss – Cash Dividends – Stock Dividends 

This leads us into the next ratio, Price to Sales Ratio (P/S Ratio): P/S = Stock’s Current Price ÷ Revenue . P/S Ratio gives us an idea of how much a stock costs per $1 of sales earned. You can utilize this in much the same way as the P/E ratio from a comparative standpoint as well as comparing to the historical standard. Additionally, the P/S Ratio can be utilized for companies that may be newer & are yet to achieve profitability. In this scenario, the P/S Ratio can be the best indication of what the market expects from the company’s potential. To this degree, a high P/S Ratio would be an indication of a high future revenue growth curve.

Market Cap indicates how much it would cost to buy 100% of the company’s shares outstanding. Market Cap = Stock’s Price x # Shares Outstanding . Alot of individuals new to the market, I see them assess the value of a stock based on it’s current price when in reality, I believe Market Cap can give one a much better picture of what the market is valuing the company at.  Company’s can (& do) alter their stock’s current price via share splits (ex: 2-for-1 stock split) or a reverse stock split (ex: 3-to-1 reverse split). We typically see these splits or reverse splits if a company believes their shares have gotten either too expensive or too cheap on a dollar-basis. If however, a company does a split, so long as the stock’s subsequent price doesn’t change too drastically, their market cap won’t change drastically, even if their price per share were to drop by $100-$200 per share due to the split.

Enterprise Value indicates, in short, the current total value of a company. Enterprise Value (EV) = Market Cap + Total Debt + Accounts Payable – Accounts Receivable – Cash & Equivalents . As illustrated in the formula, the enterprise value calculates what it would cost to buy all of the company’s outstanding stock & pay off their total debt along with their accounts payable. On the other hand, the accounts receivable & Cash & equivalents the company holds help us out in covering those debts, hence why we subtract them from how much it would cost to buy the company & cover it’s debts.

That concludes the first part of this series, but I’ll be started on part 2 throughout this week where I’ll look to expand on Return on Assets (ROA), Return on Equity (ROE) & Return on Investments (ROI) so we can better assess performance-related measurements on names that catch our eye.

Cheers all,

Zach Veencamp