There are two kinds of investors. One will pick a stock by looking at the fundamental value of a company. The second tries to guess how the market may behave based on the psychology of people in the market and other market factors. There are two kinds of investors. The first, a more conservative type, will pick a stock by looking at the fundamental value of a company. This investor believes that so long as a company is well run and keeps making more money, the stock price will go up. Fundamentalists try to buy growth stocks, those that seem likely to keep growing longer term.
The second investor tries to guess how the market may behave based on the psychology of people in the market and other market factors. This type is known as a technical investor, or "Quant." For them the market is like an auction, where the price of a stock soars as eager buyers bid it up – often in ways quite unrelated to its real value. They take higher risks with higher potential returns (and losses).
We will deal with both types and the kinds of tools each uses to reduce their risks and to increase returns. In fact, most successful investors use tools out of both camps for this purpose. We will begin with the first, the Fundamentalist.
To find the intrinsic value of a stock, many factors must be considered. When the price of the stock reflects its value, it will have reached the goal of an "efficient" market. Again,
Efficient market theory: Stocks are always correctly priced since everything publicly known about the stock is reflected in its market price.
(Or, analyzing stocks is a waste of time because all available information is already reflected in current prices.) Some basic truths:
Price is set by the stock market. Value is determined by analysts who weigh all information known about a company. Price and value are not necessarily equal. If the efficient market theory were correct, prices would instantly adjust to all available information. However, stock prices move above and below company values for many reasons, not all rational. An example is the irrational influence news has on the market, both national and global.
Fundamental Analysis attempts to forecast the future value of a stock by analyzing current and historical financial company strength. Analysts try to see if the stock price is over or under valued and what that means to its future. There are dozens and dozens of factors used for this purpose. Before we launch into this task of valuing, or putting a reasonable price on a stock, we must understand the following categories or "viewpoints" through the eyes of investors:
Value Stocks: Those undervalued by the market, the bargains where we pay 50 cents for a dollar of value. Growth Stocks: Those with earnings growth as the paramount consideration. Income Stocks: Investments that provide a steady flow of income, usually through dividends. Bonds are common investment tools used to produce income. Momentum Stocks: Emerging growth companies whose share prices are rapidly increasing.
We consider the following factors sufficient to make sound fundamental decisions. How they are used will often depend on investor bias, outlined as "viewpoints" above:
Earnings: Company earnings are the bottom line – they are the profits after taxes & expenses. The stock & bond markets are driven by two powerful forces, earnings and interest rates. The flow of money into these markets is ferociously competitive, moving into bonds when interest rates go up and into stocks when earnings go up. It is a company's earnings, more than anything else, that creates value. (There are certain caveats to this idea that must be considered)
Earnings per Share EPS: The amount of reported income, on a per share basis, that the company has available to pay dividends to common stockholders or to reinvest in itself. This can be very powerful to forecast the future of a stock's price by giving a more complete view of the company's condition. Earnings Per Share is probably the most widely used fundamental ratio.
The price/earnings (P/E) ratio is another useful measure of whether a stock is fairly priced. If the company’s stock is trading at $60 and its EPS is $6 per share, it has a multiple, or P/E of 10. This means that investors could expect a 10% cash flow return:
$6/$60 = 1/10 = 1/(PE) = 0.10 = 10%
If it’s making $3 per share, it has a multiple of 20 (20 times $3 equals $60). In this case, an investor might receive a 5% return (if conditions remain the same going forward);
$3/$60 = 1/20 = 1/(P/E) = 0.05 = 5%
Certain industries have different P/E’s. Banks have low P/E’s – say, in the 5 to 12 range. High tech companies have higher P/E’s – say, around 15 to 30. (...and we all remember the triple-digit P/E's of the internet-stock bubble. These were stocks with no earnings but sky-high P/E's. So much for market efficiency!)
If your bank P/E is at 9 and the average is 8, you are paying a premium for the stock. It’s okay if you expect higher earnings. If your retail sector P/E is 16 and the company you’re considering has a P/E of 12, then you’re getting it at a discount, but be wary of why!.
A low P/E is not a pure indication of value. You must consider its price volatility, its range, its direction, and any news that is worthy. The best use of the P/E is to compare companies in the same industry.
The Beardstown Ladies suggest that any P/E under 5 and over 35 is suspect. The market average has been between 5 to 20 historically.
Peter Lynch suggests that we should compare the P/E ratio with the company growth rate. If they are about equal, he considers the stock fairly priced. If it is less than the growth rate, it may be a bargain. In general, a P/E ratio that's half the growth rate is very positive, and one that is twice the growth rate very negative.
William J. O'Neal, founder of the Investors Business Daily, found in his studies of successful stock moves that a stock's P/E ratio has very little to do with whether a stock should be bought or not. He says the stock's current earnings record and annual earnings increases, however, are indispensable.
A key issue: The value as represented by the P/E and/or Earnings per Share are no good to you prior to your stock purchase. You make your money after you buy the stock, not before. Therefore, it is the future that will pay you – in dividends and growth. That means you need to pay as much attention to future earnings estimates as to the historical record.
Price/Sales Ratio (PSR): This is similar to the P/E ratio, except that the stock price is divided by sales per share rather than earnings per share.
Many analysts consider the PSR a better indicator of value than the P/E, since earnings often fluctuate dramatically, while sales tend to follow more consistent trends (Sales and Revenue are the same).
Another reason is the PSR may be a more accurate measure of value since Sales is more difficult to manipulate than earnings! We know how the credibility of financial institutions have suffered through the Enron/Global Crossing/WorldCom, et al, debacle. We've learned how manipulation does go on. Another reason to become your own financial manager!
The PSR by itself is not terribly effective. Rather, it is used in conjunction with other measures. James O'Shaughnessy in his book "What Works on Wall Street," found that when the PSR is used with a measure of relative strength, in becomes in his words, "the King of value factors."
Debt Ratio:This ratio shows the percentage of debt a company has relative to shareholder equity. That is, how much a company's operation is being financed by debt.
Smaller is better. Under 30% is good, over 50% is bad. A company’s debt load can suck the life out of what might otherwise be a successful operation with growing sales and a well marketed product. Earnings are sacrificed to service the debt. Equity Returns (ROE): Return on equity is found by dividing net income after taxes by owner's equity.
Many analysts consider ROE the single most important financial ratio applying to stockholders and the best measure of a firm's management performance. This gives stockholders confidence their money is being well-managed. What is important with this number is whether it has been increasing from year to year.
Price/Book Value Ratio (aka Market/Book): A ratio comparing the market price to the stock's book value per share. Essentially, the price to book ratio relates what the investors believe a firm is worth to what the firm's accountants say it is worth per accepted accounting principles. A low ratio says the investor's believe the firm's assets have been overvalued on its financial statements.
Theoretically, we would like the stock to be trading at the same point as book value. In reality, most stocks trade either at a premium (some value above book) or at a discount (when the share price is below book value). Stocks trading at 1.5 to 2 times book value are about as high as we should go when searching for value stocks. Growth stocks justify higher ratios, with the anticipation of higher earnings. The ideal, of course, would be stocks below book value, at wholesale prices. Companies with low book value are often targets of a takeover. Book value used to be important, conceived in a time when most industrial companies had actual hard assest like factories to back up their stock. However, the value of this measure has decreased as companies with low capital have become commercial giants (i.e. Microsoft). In other words, look for low book value keep the data in perspective.
Beta: A number that compares the volatility of the stock to that of the market. A beta of 1 means that a stock price moves up and down at the same rate as the market as a whole. A beta of 2 means that when the market drops or rises 10%, the stock is likely to move double that, or 20%. A Beta of zero means it doesn't move at all and a negative Beta means it moves in the opposite direction of the market.
Capitalization: The total value of all a firm's outstanding shares, calculated by multiplying the market price per share times the total number of shares outstanding.
Institutional Ownership: The percent of a company's outstanding shares owned by institutions, mutual funds, insurance companies, etc., who move in and out of positions in very large blocks. Some institutional ownership can provide stability and contribute to the roll with their buying and selling. This is an important indicator to us because we can piggy-back on the extensive research done by these institutions before taking it into their portfolios. The importance of institutions in market action cannot be overstated since they account for over 70% of the daily dollar volume traded!
Market efficiency is always a goal in the marketplace. We all want to get the value we pay for. However, as mentioned earlier, the market will always overvalue and undervalue common stocks due to the human emotions that drive it. Our task is to take advantage of this pattern with modern computing tools to find those most undervalued as well as those respond to market patterns, e.g. rolling within a channel, or recognizing trends, with intelligence.
Peter Tanous, after interviewing the most prominent investors in the market today, "Investment Gurus," New York Institute of Finance, 1997, came away with this conclusion:
"I think that our gurus proved the point without a doubt. The efficient market theory is flawed. There are simply too many examples of stocks that were discovered by a great manager before anyone else knew what was going on. Does that mean the market is inefficient? No. Here is the conclusion I have arrived at: The market is not perfectly efficient at all times. However, the market is constantly in the process of becoming efficient. By that, I mean it takes time for efficiency to be achieved."
Quotations from INVESTMENT GURUS by Peter Tanous. Copyright (c) 1996. Reprinted with permission of Prentice Hall Press, a Division of Prentice Hall Direct. Available in bookstores.
And that is why we must do our homework! The Pro-fundity(sm) Page can provide a boost to our understanding and successful market experience. Be Diligent, Take Action.
About the Author
Bob is the co-founder of Pro-fundity, an Internet forum for beginning investor improvement, helping investors think and do for themselves. The difference between success and failure in the market is razor thin. That balance is tipped predominantly to those that learn as much about themselves as the market. Pro-fundity helps that happen!