Basic fundamental analysis putting the company into context
Even the most basic fundamental analysis cannot be complete without a context for the examination, because every corporate financial milestone is dependant upon its industry sector. Itâ€™s important to know, for example, if a particular firm is expecting 25% sales growth in the near term. But if the industry average, at that point in the economic cycle, is 55%, then the company under investigation may be more a short-selling opportunity than a potential long market entry.
For this reason, itâ€™s important for the trader, when delving into fundamental analysis, to understand an industry sectorâ€™s averages and expectations. As a beginning, it helps to know whether an industry is:
â€¢Â Â Â growth-oriented, such as information technology and health care, in which case the member companies tend to display above-average growth rates compared to the overall market, or
â€¢Â Â Â value-oriented, such as consumer staples and energy, where traders expect to see below-average but still decent growth rates compared to the overall market.
Note that growth-oriented industry sectors tend to have higher valuations and price to earnings (P/E) ratios, while value-oriented sectors tend to have lower ones.
Particularly for longer-term traders, expectations for a companyâ€™s performance, and therefore its share price, should be filtered through the lens of its competition. For example, a company with sound financials and decent growth may be trading at a discount to its industry sector merely because its fiercest competitor has sterling financials and a hot new product thatâ€™s controlling the market.
One idea for traders sifting through a number of trading opportunities within an industry sector is to draft a table listing various fundamental metrics, providing an easy method of comparing market valuations. The most popular such metrics are:
â€¢Â Â Â Forward P/E, which divides the companyâ€™s share price by its earnings expectations over the next year. This one is particularly important, as earnings tend to drive share market prices.
â€¢Â Â Â Price to cash flow, which is difficult for companies to manipulate or paper over if thereâ€™s a financial problem. If not published separately, this ratio is calculated by dividing the companyâ€™s market capitalisation by its trailing twelve-month cash flow, found on the cash flow statement.
â€¢Â Â Â Price/earnings to growth, or PEG ratio, which is the only commonly used ratio which takes a companyâ€™s growth rate into account. Again, if not readily available, this ratio is calculated by dividing the companyâ€™s trailing P/E ratio, the one commonly provided by financial publishing websites, by its annual EPS growth rate.
â€¢Â Â Â Price to sales ratio, which is the companyâ€™s market cap divided by its total sales. This ratio is useful for firms which donâ€™t have positive earnings; however, it should only be used within an industry sector and never across market lines.
With all four of these ratios, the lower the figure calculated, the less expensive the stockâ€™s price.
Popularity: 100% [?]