Fundamental Analysis

The basic principal of fundamental analysis is to work out the value of a share or stock. What will you gain by owning it? Is it more expensive than other similar stocks or compared to the market average? Is the company at risk due to excessive debt or safe because it has a lot of assets on its balance-sheet etc. Is the market in general overpriced compared to historic averages?

The favoured ratios used by investors are generally published in publications like "The Financial Times" or any financial web-site, so you don't even need to calculate them, although the calculations are easy to do.

Price Earnings: PE Ratio

The PE ratio is perhaps the one fundamental analysis experts look at first. This is simply the price of a stock divided by the earnings per share (EPS), or how many years will it take you to get your money back.

PE = Price / Earnings

This figure will be quoted by many financial publications for stocks and shares and averages for whole markets. It may also be quoted for last years earnings or next years predicted earnings. It allows quick comparison of how expensive an asset is, but be careful because different industries have different average PEs and growth stocks will generally have far higher PE ratios than large blue-chip companies. Very approximately, PE below 10 is low, but this does not mean you should buy the stock without first working out why.

Many people use just the PE ratio, the yield and yield cover (see below) to give a good idea of the type of risk and return to expected, but here are a few other ratios that can be used to analyse in more depth:

Gearing (or balance sheet gearing)

the two Gearing ratios ratio give further insight into the risk and potential returns of the company.

Gearing = DEBT / Share-holder funds

A low value would be < 100 %
A medium value = 100% to 200%
A high value > 200%

Income Gearing = Total debt interest / Profit from which debt will be paid

low < 25 %
medium = 25% to 75%
high > 75%

Two other values you may find quoted are:

Return of Capital Employed (ROCE)

low profitability < 10 %
medium = 10% to 20%
high > 20%

Pre-tax profit margin

low < 2%
medium = 4% to 8%
high > 8%

EV/EBITDA

Ratio of "Enterprise Value / Earnings Before Interest, Taxes, Depreciation and Amortisation" is often quoted and is an alternative to the simple P/E ratio. The reciprocal, EBITDA/EV is the cash return on investment.

Price to Book

Price to Book = Share Price / (Net assets per share)

Share is cheap if < 1.0 i.e. the company is worth more than its assets

Tobin's Q

Tobin's Q = Cost of replacing the firm / Market value of the firsm

i.e. is the company more expensive than starting a new competing firm?

Another important number to look at is the Dividend Yield of a stock. How much will you get paid in return for taking the risk? This is quoted as a percentage and may be the forward yield (predicted) or the actual yield received over the previous year.

Yield = Dividend Earnings / Price

This allows comparison with cash yields (i.e. no risk) and other shares. Some companies will not pay any dividend and will plough all of their earnings back into investments, expansion, R&D etc. so this is more relevant for Blue-Chip companies than small growth stocks. Always compare similar companies and compare against the market average.

Dividend Cover

The next problem is how safe is the dividend yield? Will the company actually pay out? Some indication of whether the company can afford to pay the next dividend is given by the dividend cover How many times is the dividend payout covered by the companies earnings. This is, again, quoted in many financial publications. A cover of 1 mean that they can just afford to pay the predicted dividend. Anything higher than that adds a margin of safety.

The PE ratio is the easiest to understand and seems like a perfect way to compare shares, but there are complications. For instance it can only be accurately be used for comparing shares of similar companies with similar growth rates, otherwise it is just a guideline: e.g. if one company is growing fast and another is not growing then you might accept a higher PE ratio (and a lower yield) alternatively look at the PE to Growth ratio i.e. divide the PE by the growth rate and you get the PEG ratio or for more complex analysis look at the dividend-discount model below:

PEG Ratio = (P / E) / (Annual Earnings per Share Growth)

This is only an approximation, but PEG was popularized by the master investor, Peter Lynch who wrote "One Up on Wall Street" in which he said "The P/E ratio of any company that's fairly priced will equal its growth rate", i.e. a fairly valued company would have PEG = 1.0. PEG allows companies with different growth rates to be compared.

Here is some more complex maths:

Price = dividend / dividend yield assuming no growth

Using dividend-discount models for constant-rate growth (i.e. dividend yield is derived from the required return minus the rate of dividend growth)

P = D / (k - g)

where:
P = Share Price
D = Next Dividend
k = required rate of total return
g = rate of growth of dividends

So the share price can be determined from the forecast dividend yield divided by the rate of return the investor hopes to get minus the rate at which dividends are expected to grow. If you know the price and the required return you can calculate how fast the company needs to grow dividend in order to achieve this.

and the PE ratio simply becomes:

PE = (D / E) / (k - g) = Payout ratio / dividend yield

E = Forecast earnings per share
Payout ratio = proportion of earning that will be paid to the investor

i.e.

if Payout ratio increases so does PE

higher growth => higher PE

higher required return => lower PE

but if Payout ratio increases the growth rate goes down and the required return might go up (to account for extra risk)

So the PE ratio is more complex than originally thought, but is still a useful tool to interpret what is happening in the company.