FUNDAMENTAL ANALYSIS

A business or financial analysis technique that seeks to understand behavior by using complex mathematical and statistical modeling, measurement and research. By assigning a numerical value to variables, quantitative analysts try to replicate reality mathematically.

Quantitative analysis can be done for a number of reasons such as measurement, performance evaluation or valuation of a financial instrument. It can also be used to predict real world events such as changes in a share price.

In broad terms, quantitative analysis is simply a way of measuring things. Examples of quantitative analysis include everything from simple financial ratios such as earnings per share, to something as complicated as discounted cash flow, or option pricing.

Although quantitative analysis is a powerful tool for evaluating investments, it rarely tells a complete story without the help of its opposite - qualitative analysis. In financial circles, quantitative analysts are affectionately referred to as "quants", "quant jockeys" or "rocket scientists.

Price Earning Ratio

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. Another investor may not see the same value and think your "right" P/E is all wrong.

Projected Earning Growth

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

Price To Sales

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.

Price To Book Ratio

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.

Dividend Payout Ratio

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).

Dividend Yield

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)

Book Value

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.

Return on Equity

If 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.