Fundamental Analysis is the term used to describe the process of analysing a company's financial figures to determine what price a share should trade at.
Fundamental analysis starts with a company's financial accounts, the Profit & Loss Statement, Balance Sheet and Cash Flow Statement. Various ratios are calculated to help the analyst and investor form an opinion of a company and it's share price.
In the business pages of the bigger daily papers you will find tables of figures already calculated for you, invariably these will be historic ratios, which can tell us how the company has performed in the past. These ratios are of no value until compared with other companies, historical figures of the company itself and alternative investments.
You must understand that many figures are only useful for comparing a company's future prospects with how it has done in the past and cannot be used to compare one company's share price with another. I have often heard people referring to a particular share as expensive simply because it has a big number as its share price. A $10 share is not necessarily more expensive than a $1 share. Each company has a different number of shares on issue so the company's assets and profits are being divided amongst different numbers of investors. Two companies could be identical in every way but if one has twice as many shares on issue it will theoretically trade at half the price of the other, if its not that may represent an opportunity to buy (or sell).
Think of parcels of mince in the supermarket. If a 250gm pack costs $3.00 and a 500gm pack $5.00. I hope you can see that the 500gm pack represents better value for money than the 300gm pack. You can say that the 500gm pack is cheaper even though the unit price is higher. Shares also come in different sizes, and the ratios calculated are like converting grocery prices to a cost per kilo. But just like mince its not just the price we are concerned with. With mince we are concerned with type of meat, fat content, freshness perhaps even country of origin. We might be prepared to pay more for 500gm of lean pork mince from a local farmer than a 500gm pack of dodgy looking beef from Australia.
Like mince the components that make up the company are important, how it makes a profit, the business it is in and the likelihood that it will continue in business and maintain or increase profitability.
There are a number of simple financial ratios that even the casual share investor should understand.
Earnings per Share (eps)
Earnings per share is calculated by dividing how much the company earns (or profit) by the number of shares on issue. Growth in eps is a good sign and bigger is better. Comparing a company's historical eps with current and forecast figures can tell you whether a company's profitability is getting better or worse. But on its own eps cannot be used to compare one company with another. To compare the earnings of one company with another we look at the Price Earnings ratio.
Price Earnings ratio (PE)
Price Earnings ratio (PE) is earnings per share divided by the share price. We can compare historical and forecast PE's of a company and can compare PE's between companies. A market average PE is can also be calculated. The lower the PE ratio the more profit you are getting for each dollar you invest. It can also be viewed as the number of years it takes the company to earn the share price. PE ratios should not be be viewed in isolation you must always compare it with something. All other things being equal the higher the PE ratio the more expensive the share is.
PE ratios vary from industry to industry as well as over time. During a bull market (when share prices are generally rising) PE ratios tend to be higher than in a Bear Market (when share prices are generally falling). The PE can help indicate whether a share might be over or under priced, if the average PE of a company over time has been 12 and it is currently 18 perhaps its getting a little expensive. On the other hand if the PE of other companies in its industry sector have also increased by a similar amount perhaps it represents fair value because the prospects for that industry have improved.
The higher the PE the higher the growth prospects the market is expecting from the company which the market believe will be reflected in a higher share price in the future. A company that is growing quickly should have a higher PE than a company that is not.
The PE ratio is an indicator of how much growth there might be in the price of a share over time.
Dividends per Share (dps)
The dividend is the amount that the company pays to its shareholders and so represents income to the investor. Dividends per Share (dps) is the amount of the dividend the company pays per share, it is usually expressed in cents. Dividends are most often paid twice a year. Generally the higher the dividend per share the better as it represents more income to the investor, however a company that is growing strongly may not pay a dividend at all and this could be seen as a good thing if its growth prospects are good. Rather than giving the money to shareholders it is reinvesting in the business in order to generate higher profits in the future. But we can't use dps to compare dividends between companies we need to calculate another ratio, the Dividend Yield.
The Dividend Yield is the dividend per share divided by the share price. It represents the return to the investor expressed as a percentage. This is the figure that you can compare to the interest rate you might be getting on your term deposit, after allowing for any franking credits. You can directly compare the Dividend Yield of two companies with different share prices. All other things being equal a higher dividend yield is better. However a share with a high dividend yield may not necessarily represent a good investment because it may be in a risky or highly cyclical industry.
The Dividend Yield indicates what income you might receive on your investment over time.
In general the higher the Dividend Yield the lower the PE Ratio.
At the very minimum I believe you should have a good idea of a company's current, historical and forecast Dividend Yield and PE Ratios when deciding whether to buy or sell a company's shares. There is no "correct" PE or Dividend Yield they must always be used in comparison with other shares and alternative investments.
A good source of historical information on listed New Zealand and Australian companies is the New Zealand Investment Year Book available from Investment Research Group for $49.95. You can click here to order the New Zealand Investment Yearbook on-line.
If you are going to seriously get into share investing a great source of information is the Investment Research Group on-line database which offers a treasure trove of regularly updated New Zealand listed company data, including 8 years of financial history, Stock Exchange announcements, annual report excerpts, daily price and market index histories and much more. To arrange a subscription click here to arrange a subscription online.
Whilst writing this article I came across Damadoran Online the website of Aswath Damodaran. a Professor of Finance at the Stern School of Business at New York University. I found his writing relatively easy to understand, it might be a good place to go if you want to investigate this topic further. To visit To visit Damadoran Online click here. It will take you to a page that gives a list of many of the ratios that may be calculated to help with the fundamental analysis of a company together with simple explanations and comments.
Next week I'll cover the basics of technical analysis of share prices.
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