There are no set “weighting” exercises to evaluate a stock, in the end it comes down to your feelings and the risk you’re willing to take, the direction you want to go.
A dispassionate look at a stock. This stresses economic conditions, examines a firm’s earning capacity, its growth potential, and its sources of finance. Ratios, financial data, and astute observation are the primary tools of fundamental analysis.
This approach is based on the premise that real factors, such as the firm’s productivity and profitability, will ultimately govern the stock’s price.
Uses charts to identify significant market trends and/or specific stock turns, based on past performance, emphasizing price trends and deviations from those trends.
For example, stocks that are rising in price will usually continue to do so. When the technical analyst perceives that this trend is coming to a halt, it is time to liquidate the position in that security, even if the firm has superior management, excellent growth potential, and a strong balance sheet.
This approach stresses market factors and suggests that future stock prices are related to past market behavior.
Charts tell us things the same way a doctor might – what is the past history, the diagnosis, the chances, the effect of certain factors like diet or exercises.
Fundamentals give people opinions, technicals try to confirm these opinions. Both help reduce the risk.
Following are five ways to use fundamentals to evaluate potential stock buys:
- Earnings (the most important measuring stick for stock value): That is, if a company is not earning money, it is more likely to go south. The best measure of this is the P/E ratio, Price over earnings ratio. More earnings relative to the stock price, the lower the P/E ratio. If the Price is very high compared to earnings, it will be overvalued. Very low P/E ratios means the price is low, or it is undervalued. The lower the P/E ratio, the greater the discount. In looking at earnings, you’ll want current figures as well as where the company has been. What is the history, increasing, flat, or decreasing? P/E for banks is low, say in the 5 to 12 range. High tech have higher P/E’s, around 15 to 30. If our bank is at 9 and the sector average is 8, we are paying a premium for the stock. If our food sector P/E is 16 and the company we’re considering has a P/E of 12, then we’re getting it at a discount. Check the historical level (P/E) of the stock. If the current P/E is above the 5 or 15 year historical P/E, the movement of the stock may be about to drop back into line.
- Yield (dividend payout): Look for companies with great profits, but be content with that money going back into the business, instead of dividend payout which is highly taxed. If we are investing for income, dividends may be a good choice, but for growth in the long term, dividends are not that attractive.
- Book Value: Subtract all liabilities (including preferred stock) from assets, then divide by the number of shares outstanding, to get value per share. This number tells us how much of each share is real value. The main reason to study this is to make sure we are not overpaying for a stock. In theory, we want what the stock is trading at to be the same as the book value. Some like stocks trading 1 ½ to 2 times book value, while frowning on stocks over 3 times book value. One possible play is to look for companies with low book value because they are often the target of a takeover. Book value is also known as “shareholder equity.”
- Equity returns: Return on stock equity is the company’s after tax profit divided by the book value. The important thing here is to see if this return is increasing from year to year.
- Debt Ratio: This runs a close second to earnings. This is the percentage of debt a company has in relationship to shareholder equity. High debt decreases earnings to service the debt.
These five fundamental tools help us calculate and take successful risks.
When in doubt, FOLLOW EARNINGS!
Fundamental and technical analysis help us predict future price movement. And it is the use of these tools that reduces our risk, separating the winners from the losers.
Investors realize they must take calculated risks. Unfortunately, the future is uncertain, and while some investments are less risky than others, the fact remains that any investment decision involves a calculated risk. Rich rewards, as either an investor or a trader, flow to those who successfully manage risk.
Investors favor fundamental data, while a Trader deals more with the technical (particularly the study of charts). However this is not a conclusive departure for the two, since both are very aware of their relationship.
Timing in the market is difficult. How do you know how high is high and when it’s time to sell, and then how low is low and when it’s time to buy? Clearly, success in the market is a non-trivial issue! The goal is to hit a lot of singles and a few homers all the while trying to avoid too many strike outs. And George Patton sums it up nicely:
George Patton – “Take calculated risks, that is quite different from being rash.”