There are some big critics of Fundamental Analysis of stocks who believes in Efficient Market Hypothesis. They say that one can never get the benefit of fundamental analysis as the market price always immediately corrects itself for every bit of good or bad news (instantly). But never mind that these critics are in small minority and majority of other investors (qualified) has been using fundamental analysis with great success. All value investors (like Warren Buffett) has been using bits and pieces of fundamental analysis with perfection. In order to do fundamental analysis one must learn to read financial statements. Lets look at some key financial parameters that are basis of a good fundamental analysis of stocks.
Earning/Profits/Earning Per Share (EPS)
There is no denying of fact that above all parameters Earnings or profits is the most important fundamental indicator. If the profits of a company is constant or improving then it a very healthy sign. Improving earnings gives a hint to the investors that how income from stocks (in form of dividends and capital appreciation) will improve in future. But is important for an informed investor to use the valves of earnings/profits very ingeniously so that the stock valuation is fool proof. In order to do this we must use the following financial parameters linked with earnings to evaluate stocks. Always remember that improving earnings/profits does not always guarantee that the stock is a good buy/hold, we must look into the details.
Earning Per Share is more important than Earnings itself.
Two companies (A & B) makes $1 & $10 million in profits respectively, you would buy shares of which company? An intelligent investor will say that this information is not sufficient, he will say that “Unless I know the number of shares outstanding in the market I cannot take the decision”. Suppose number of shares outstanding for A is 0.5 million and for B is 10 million then EPS for A will be 2 and for B will be 1. So in terms of EPS (which is the real indicator of probable income for investors) share A looks more profitable. For long term investors it is also of prime importance to look at EPS growth rate (CAGR) for at least last five years. The higher the growth rate the better. Thumb rule is it shall be at least equal to P/E ratio. This brings us to the next fundamental indicator of stock.
EPS Growth Rate (CAGR): =(EPS5/EPS1)^(1/(Period- 1)) -1
EPS5 = EPS of year 5, EPS1 = EPS of year 1, Period = 5 years in this case
Price Earning Ratio (P/E)
Price Earning Ratio (P/E) is a great tool that investors often use to evaluate if the share is correctly valued or not. In step one we have calculated the EPS’s of last five years. I suggest you to find an average of all EPS of last five years (EPSav) and then find P/E ratio. As a rule of thumb if the P/E ratio is below 15, you can consider it a good buy. Also, if P/E ratio is equal to the EPS growth rate then the share has great buying probability. But before buying we have to look at other fundamentals as well. Note: if P/E ratio is higher than 15 it indicates that at current market price levels the share is trading at overvalued levels.
Ratio of Price to EPS Growth Ratio (PEG)
Not very often you will find a share whose P/E ratio is below 15. But this does not necessarily mean that the share is overvalued. Experts believe that if the future growth prospects of share is high (comparable) then investors can afford to pay even higher price to own that share. Suppose a share has P/E ratio of 18 and its EPS growth rate (CAGR) for last 5 years is 19% per annum, then PEG ratio will be 18/19= 0.95. When PEG ratio is less than 1 it indicates a great buying possibility. Value and growth investors has used this relatively new parameter to evaluate true value of stock very successfully. Earnings growth rate is the deciding factor in evaluating true value of stocks as this is the parameter that dictates your future earnings (capital appreciation).
Short term income in form of dividends
Not all investors can afford to invest just on the aspect of capital appreciation. If long term capital appreciation is complimented with reasonable short-term income then it is like a icing on the cake. There are share trading in the market (some blue chip stock) that gives dual advantage of long term capital appreciation and short term dividend income. But problem is such stocks are always overvalued. PEG ratio of such stock is always in multiple of 2 or 3. At this point investors must check the dividend yield along with the PEG ratio. As a rule of thumb if the dividend yield is more than 4% the stock is reasonably valued. For a long term investors it is always advisable to wait (sometimes for few years) like a eager hawk and watch the price movements of blue chip stocks. As soon as the PEG ratio and dividend yield touches the acceptable limits grab these stock instantly.
Note: When we are looking at the dividend yield as a value indicator, it is also important to look at how frequently and consistently the dividends are paid to the shareholder. An erratic and unpredictable dividend disbursement is not good for long term investors. That’s why long term investors shall also track the dividend disbursement patter. It must be predictable and reasonably high.
Dividend Payout Ratio says if present dividend yield levels can be sustained.
Suppose a share has EPS of 2 and dividend paid per share is 0.5. It means that 25% of companies earnings is distributed among shareholders as dividends. But there are companies that pays nearly 65% to 70% of their earnings as dividends. Though on one hand it is good for shareholders but also I doubt that whether such levels of dividend payouts can be maintained in future. Well establish and mature companies do pay high dividends close to 50%, but as a rule of thumb, higher dividends than 50% is not sustainable.