An Overview Of Fundamental Analysis For The Stock Market part 2

An Overview Of Fundamental Analysis For The Stock Market part 2. In this second part, we'll tackle some key concepts (PE ratio, earnings per share, debt-to-equity, net income, operating income, operational advantage, competitive advantage. And I'll even provide some free reference materials in the end.
This is part 2, if you haven't read part 1 yet, please do so.

In this second part, we'll tackle some key concepts. And I'll provide some free reference materials in the end.

Price to Earnings Ratio (P/E ratio)

One of the most over-used (maybe even misused, sometimes) metrics you'll hear when talking about the stock market. Basically it divides the stock price by the company's Earnings Per Share (which measures how much profit each share of stock earned; the higher the better of course).

The biggest thing is that it's not negative, zero or non-existant, as that meant the company isn't earning money.

It can be used to measure if the share price is over or under-priced. However, high P/E ratio can also mean (aside from being overpriced) that the market expects a lot of earnings from the company in the future. An example are Ayala company stocks, which can have PE ratios in the 30s.

Earnings Per Share

I probably should've tackled this first since this is partly what P/E ratio is based on. But honestly, P/E ratio is much more familiar to even casual stock investors.

Earnings per share (EPS) is how much "profit" each stock (or share) gets. Assuming there is no reinvestment of funds (never the case, even for old, mature businesses) this is what would be paid to you for being a part-owner of a company. But that's not why this is important.

Have you ever heard that the primary indicator/decider of share price are earnings? If the company's earnings keep growing, then it's reasonable to expect that the stock price keeps appreciating. So obviously, more money for us. :D

But that doesn't mean choosing which company has the highest EPS. What we want is a company that has consistently good (or great) earnings for the past several years.

We want a nice, steady upward trend not large up and down swings, even if it's way up right now. Which brings us to the next item...

An Overview Of Fundamental Analysis For The Stock Market part 2. In this second part, we'll tackle some key concepts (PE ratio, earnings per share, debt-to-equity, net income, operating income, operational advantage, competitive advantage. And I'll even provide some free reference materials in the end.
Operating Income vs Net Income.

Income (where earnings come from) is income right? Well, for regular folks like us, yes. But for businesses, it's important to qualify where that income came from. And there might actually be a few types, depending on the financial report you are looking at. But we'll just tackle the common ones.

Net income is basically all revenue minus expenses (I might be over-simplifying, but that's the basic idea).

Operating income is basically all income from the company's regular activities and doesn't include one-time or non-recurring income (windfalls).

There may be other "classifications" depending on what you're looking at. But it's always best to check a company's Operating Income. Why? Because it tells you if the company is profiting from its "normal" operations.

The biggest thing here is avoiding a company that relies on windfalls or capital infusions from the owner or other investors. If they can't make money on their own, it's just not worth it.

Debt

This is another important measure. For example, Bayantel was at one time a credible player in the telecommunications industry. But the last time they made a significant business move, it was to sell their bandwidth to (and get eaten up by) Globe.

In between, they went into an assisted bankruptcy because they couldn't pay their debts anymore. They were doing well enough, but then the Asian financial crisis hit.

I think pretty much all big companies have debt. But it's important to find a company that doesn't rely on too much debt to finance it's activity. Because they're a black swan away from becoming a black hole for your money.

Debt-to-equity ratio is one way to measure it (typically should be less than 2), although most sites I've been to don't have this info. You may have to compute it yourself using this formula:

Debt-to-Equity Ratio = total company debt / shareholder's equity.

An Overview Of Fundamental Analysis For The Stock Market part 2. In this second part, we'll tackle some key concepts (PE ratio, earnings per share, debt-to-equity, net income, operating income, operational advantage, competitive advantage. And I'll even provide some free reference materials in the end.
Operational Advantage vs Competitive Advantage

This is where it requires the greatest analysis. You found a stock that's raking in money. But will it keep doing so?

Operational advantage is the term used when a company is doing the same thing but more efficiently (or better) than the competitor. Their process is good. So maybe they have lower cost or higher quality, making sure they get the customers.

A good example maybe a vertically integrated manufacturing company like Cirtek Holdings (CHIPS). "Vertically Integrated" is a fancy way of saying the entire supply chain is under one owner - which brings some efficiencies and avoids some potential problems.

Another example is "experienced, talented, dedicated management".

However those advantages typically won't last long. Other manufacturing companies may become vertically integrated as well. Or other companies may hire away the great management team - or they retire and get replaced by lackluster ones.

What you really want is a company with a competitive advantage. Maybe they're doing something only they can do, like keep coming up with new gadgets that people all over the world go crazy for (hello Apple). Or maybe they've got so much market share it's practically a monopoly - even so far as to get into problems with the government (hello Microsoft).

Locally: who has never been to an SM mall? Or eaten at a fast food chain not owned by Jollibee (jollibee, mang inasal, chowking, red ribbon, greenwich, plus a bucket load of others I forgot because there's just too many and they seem to own everything hehe).

And to talk more about competitive advantage, here's Warren Buffet himself (again!)



Recap

That's basically it. There's a huge load of things to learn, but this should be enough to get you started. To recap, here are the important things to do when conducting fundamental analsyis:

Make sure the company is making money, and check everything to see if they'll keep making money in the future :)


Free References:

Investopedia has a nice article on how to conduct fundamental analysis:
http://www.investopedia.com/articles/fundamental-analysis/09/five-must-have-metrics-value-investors.asp

+Omeng Tawid over at Smart Pinoy Investor has great slides from COL Financial (my broker too!) about  Fundamental Analysis:
http://www.smartpinoyinvestor.com/2010/03/fundamentalanalysiscolfinancial.html

Actually I first learned it from a guest post over at Philstockanalysis:
http://www.philstockanalysis.com/2009/05/lets-talk-stock-market-fundamentals-1.html


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1 comment:

  1. I highly advocate fundamental analysis. For me, it's important to think of stock market as a business. In addition to being an investor, it also prepares us the fundamental knowledge to become successful businessmen in the future.

    If we know how to choose good companies based on their fundamentals, we don't need to worry much on timing the market. But of course, if coupled with skills on technical analysis, we have the great advantage.

    Your article is great, easy to understand and informative. You've provided practical examples which add more clarity to the explanation. Keep it up.

    Bombitz

    ReplyDelete