When searching for a great investment, fundamental analysis is essential.
Without it, you’re often just blindly buying a stock, hoping for the best.
Think of it as a must for gauging company health.
A fundamental analyst is simply trying to understand the intrinsic value of a company stock – or the true value of a stock by fundamentals.
They want to know:
- Is the stock overvalued / undervalued based on its price to earnings ratio?
- Is it trading at or below future growth, per its price to earnings growth ratio (PEG)?
- Is the company making a profit?
- How does the stock trade in comparison to overall sales?
- Where does the company stand with regards to competition?
When it comes to this analysis, it’s all about earnings. How much is the company making now? How much could it make in the future? Some of the key building blocks to understanding how to value a stock can be found with price to earnings (PE), price to sales (PS), price to book (PB), return on equity (ROE) and price to earnings growth (PEG) are some of the key ones to understand.
Let’s start with earnings.
Earnings are the bottom line. Earnings give an indication of future potential. Without earnings, a stock is on life support. This is the lifeblood of any company success. Earnings per share (EPS) refer to net earnings divided by the number of shares on market. For example, if ABC just reported $40 million in net earnings and has 10 million shares on the market outstanding, ABC has EPS of $4.
To define, shares outstanding refers to the total number of shares issued by a company to be traded publicly. A float is the number of shares publicly owned and available to be traded).
Price to Earnings (P/E)
This ratio examines the underlying relationship between the stock price and earnings. For example, a stock trading at $20 and EPS of 4 would have a P/E ratio of 5, or $20 / 4. This gives a fundamental analyst an idea of just how much the stock market is willing to pay for one share of said stock.
Price to Earnings Growth (PEG)
Any PEG ratio greater than 1.0 tells an analyst the stock may be overvalued. A read under 1.0 may be a strong indication of undervaluation. It’s not always a reliable indicator, though. It’s typically based on projected EPS. And, as we all know, projections aren’t always accurate.
Price to book (P/B)
Price to book allows an analyst to unearth undervalued opportunities. It’s the ratio of the market price over its book value, or the value of assets on the balance sheet. Let’s say stock ABC has $200 million in assets on its balance sheet and $80 million in liabilities. Book value would be $120 million. If we also have 20 million shares outstanding, each share of ABC would carry book value of $6 a share. If ABC then traded at $3 a share, the P/B ratio would be 2.0. This ratio helps an analyst identify lower priced stocks being discounted by the overall market.