Whether you are new to investing or a seasoned investor, it’s important for you to understand fundamental analysis as this drives stock market returns over the long term.
So, what is “fundamental analysis”? It involves a critical examination of a business in terms of its earnings potential, balance sheet, profit margin and other key indicators.
All these combined will determine the financial progress of a company as well as the intrinsic value of a stock.
If the share price is trading below the “fair value” or “intrinsic value” of the company, it would be deemed as “undervalued” and would represent a buying opportunity.
This means that eventually, when the price in the market reflects the reality of the company, the share price will go up.
However, it is worth keeping in mind that the share price is affected by other variables aside from the fair value of a company.
These factors can includes the likes of macroeconomics, global market conditions, monetary policy conditions, and other such variables.
For investors, though, here are the top five fundamental indicators that you need to keep in mind as you embark on your investment journey.
1. Price-to-earnings (PE)
The price-to-earnings ratio (PE) is one of the most popular metrics used when assessing a company’s fair value.
Mathematically, the PE simply means the share price of a company divided by the earnings.
In short, what it tells us is the value the market is willing to pay today for a stock based on its earnings.
If you’re using the past earnings, you will be looking at the trailing PE but if you’re looking at the forward (or forecasted) earnings, then it will be the forward PE.
In general, a higher PE means that the market is paying more for the same earnings earned while a lower PE means that the stock price is low compared to its earnings, which could be favourable to investors.
For example, if company A’s stock is valued at S$10 today and its earnings per share (EPS) is at S$1 per share over the last 12 months, its trailing PE would be 10 times.
Meanwhile, if the forecasted earnings over the next 12 months is expected to be S$2 per share, the forward PE would be 5 times.
You can also use PE to compare the valuation for different companies as well.
Let’s say company B is trading at S$15 today while its forecasted earnings for the next 12 months is only S$1 per share – the forward PE would be 15 times, which is significantly higher than company A.
The conclusion from this could vary but the PE tells us that company B is more expensive as compared to company A.
It could be due to overvaluation or that company B simply operates in an industry that is being valued at a premium in comparison to company A.
While PE alone cannot determine the intrinsic value of a company, it tells investors how much the market is willing to pay for the earnings generated at that moment in time.
One of the downsides to using PE is that it is only suitable for the evaluation of companies that are profitable.
2. Price-to-Book (PB)
While PE looks at earnings, the price-to-book (PB) ratio compares the market value (share price) to the book value of the company.
Book value is basically the cost of all equities minus off its liabilities and could be seen as the theoretical value of a company if it liquidated itself.
In reality, the value would be lower as liquidation usually results in lower gains as compared to what is shown on the book value.
The PB ratio of a particular company, however, is not useful on its own. An investor needs to compare the PB of a company with others in the same industry to determine if the company is overvalued or undervalued relative to its peers.
Most investors look at PB when evaluating financial companies and companies that are loss making currently.
3. Earnings Per Share (EPS)
Earnings per share (EPS) is equivalent to the bottom line of the company or the net profit divided by the total number of outstanding shares.
In short, it is the net profit of a company measured on a per share basis.
A growing EPS is a positive sign as it shows to investors that business growth is taking place.
4. Free Cash Flow (FCF)
Free cash flow (FCF) basically means the remaining cash left after the payment for operating and capital expenditures. Cash is critical to ensure the continuity of businesses.
FCF is calculated by taking the operating cash flow minus the capital expenditures.
FCF helps investors to understand if the company has enough cash to reward its shareholders through dividends or reinvest its earnings into development, or improvement, of its business in order to add value to shareholders.
5. Return on Equity (ROE)
Finally, Return on Equity (ROE) evaluates the return on investment of a company. It basically tells us how well a company generates positive return to its shareholders’ investment.
You can calculate ROE by dividing the net income by average shareholders’ equity:
ROE = Net Income/Average Shareholders’ Equity
Using DuPont analysis, you will be able to better understand the company’s profitability:
ROE = Profit Margin x Turnover Ratio x Leverage
ROE = Net Income/Revenue x Revenue/Assets x Assets/Average Shareholders’ Equity
With DuPont analysis, an investor will be able to understand if changes in ROE are due to the profit margin, turnover ratio or leverage undertaken by a company.
This provides a better understanding on the operations of the company and the growth prospects going forward.
No one-size-fits-all solution
All the fundamental analysis tools I talked about above are important. However, there is no one indicator that could tell you the entire story of a company due to the complexity of running a business.
It is important to remember that the share price of a company or stock is determined by various factors and variables that are difficult to measure and forecast.
While these indicators alone can’t determine the value and growth potential of a company going forward, combining these indicators can help you understand the company better.
It offers you a perspective on how the market views the stocks or companies at the moment, and helps you to develop a clearer picture of the company as well as the benchmarks used to measure the worth of potential investments.
Investors could benefit by using fundamental analysis in tandem with technical analysis (TA), macroeconomic developments and other industry-specific data to make better investment decisions.
