Tools of Fundamental Analysis

Tools of Fundamental Analysis

Fundamental analysis is the process of looking at a business at the basic or fundamental financial level. This type of analysis examines key ratios of a business to determine its financial health and gives you an idea of the value its stock.

Many investors use fundamental analysis alone or in combination with other tools to evaluate stocks for investment purposes. The goal is to determine the current worth and, more importantly, how the market values the stock.

This article focuses on the key tools of fundamental analysis and what they tell you. Even if you don't plan to do in-depth fundamental analysis yourself, it will help you follow stocks more closely if you understand the key ratios and terms.

Earnings

It's all about earnings. When you come to the bottom line, that's what investors want to know. How much money is the company making and how much is it going to make in the future. Earnings are profits. It may be complicated to calculate, but that's what buying a company is about. Increasing earnings generally leads to a higher stock price and, in some cases, a regular dividend.

When earnings fall short, the market may hammer the stock. Every quarter, companies report earnings. Analysts follow major companies closely and if they fall short of projected earnings, sound the alarm. While earnings are important, by themselves they don't tell you anything about how the market values the stock. To begin building a picture of how the stock is valued you need to use some fundamental analysis tools. These ratios are easy to calculate, but you can find most of them already done on sites like cnn.money.com or MSN MoneyCentral.com.

Fundamental Analysis Tools

These are the most popular tools of fundamental analysis. They focus on earnings, growth, and value in the market.

The articles are:

1. Earnings per Share - EPS

2. Price to Earnings Ratio - P/E

3. Projected Earning Growth - PEG

4. Price to Sales - P/S

5. Price to Book - P/B

6. Dividend Payout Ratio

7. Dividend Yield

8. Book Value

9. Return on Equity

No single number from this list is a magic bullet that will give you a buy or sell recommendation by itself, however as you begin developing a picture of what you want in a stock; these numbers will become benchmarks to measure the worth of potential investments.

Understanding Earnings per Share

One of the challenges of evaluating stocks is establishing an "apples to apples" comparison. What I mean by this is setting up a comparison that is meaningful so that the results help you make an investment decision.

Similarly, comparing the earnings of one company to another really doesn't make any sense, if you think about it. Using the raw numbers ignores the fact that the two companies undoubtedly have a different number of outstanding shares.

For example, companies A and B both earn $100, but company A has 10 shares outstanding, while company B has 50 shares outstanding. Which company's stock do you want to own?

It makes more sense to look at earnings per share (EPS) for use as a comparison tool. You calculate earnings per share by taking the net earnings and divide by the outstanding shares.

EPS = Net Earnings / Outstanding Shares

Using our example above, Company A had earnings of $100 and 10 shares outstanding, which equals an EPS of 10 ($100 / 10 = 10). Company B had earnings of $100 and 50 shares outstanding, which equals an EPS of 2 ($100 / 50 = 2).

So, you should go buy Company A with an EPS of 10, right? Maybe, but not just on the basis of its EPS. The EPS is helpful in comparing one company to another, assuming they are in the same industry, but it doesn't tell you whether it's a good stock to buy or what the market thinks of it. For that information, we need to look at some ratios.

Before we move on, you should note that there are three types of EPS numbers:

* Trailing EPS - last year's numbers and the only actual EPS

* Current EPS - this year's numbers, which are still projections

* Forward EPS - future numbers, which are obviously projections

Understanding Price to Earnings Ratio

If there is one number that people look at than more any other it is the Price to Earning 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