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. It’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, it’s important for the trader, when delving into fundamental analysis, to understand an industry sector’s averages and expectations. As a beginning, it helps to know whether an industry is:

•    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
•    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 company’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 that’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:

•    Forward P/E, which divides the company’s share price by its earnings expectations over the next year. This one is particularly important, as earnings tend to drive share market prices.
•    Price to cash flow, which is difficult for companies to manipulate or paper over if there’s a financial problem. If not published separately, this ratio is calculated by dividing the company’s market capitalisation by its trailing twelve-month cash flow, found on the cash flow statement.
•    Price/earnings to growth, or PEG ratio, which is the only commonly used ratio which takes a company’s growth rate into account. Again, if not readily available, this ratio is calculated by dividing the company’s trailing P/E ratio, the one commonly provided by financial publishing websites, by its annual EPS growth rate.
•    Price to sales ratio, which is the company’s market cap divided by its total sales. This ratio is useful for firms which don’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 stock’s price.

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