Basic Fundamental Analysis
for Stocks
Basic Fundamental
Analysis for Stocks
Table of Contents
Basic Fundamental Analysis for Stocks
Free
Cash Flow vs. Operating Cash Flow
Operating
Income vs. Net Income
EBITDA
Margin, AKA Operating Profitability
Basic EPS
Basic Earnings per share (EPS) is calculated as
a company's profit divided by the outstanding shares of its common stock. The
resulting number serves as an indicator of a company's profitability, how much
money a company makes for each share of its stock.
If a company has a complex capital structure where
the need to issue additional shares might arise then diluted EPS is considered
to be a more precise metric than basic EPS. Diluted EPS takes into account all
of the outstanding dilutive securities that could potentially be exercised
(such as stock options and convertible preferred stock) and shows how such an
action would affect earnings per share.
Basic EPS = Net Income – Dividends paid / Number of
shares outstanding
P/E Ratio
The Price-to-Earnings Ratio (P/E ratio) is the best
indicator of how expensive a stock is. The actual price of a share, on the
other hand, is relatively meaningless.
The P/E is simply the price per outstanding share
divided by earnings per share of the past 12 months.
It shows how much
investors are paying for a dollar of profits. Historically, the average P/E ratio is 15.7.
Today, the S&P 500 P/E is 26.25. P/E ratios can range from none for
companies without profits, to the triple digits for companies with slim profits
and high prices, and single digits for companies in decline.
What is a good PE ratio?
The average P/E for the S&P 500 has
historically been at 16.8. For example, a company with a current P/E of 50,
above the S&P average, trades at 50 times earnings. The high multiple
indicates that investors expect higher growth from the company compared to the
overall market.
Undervalued Overvalued
Stocks
Divide the market price per share by the book value
per share. A stock could be undervalued if the P/B ratio is lower than one.
Divide the market price per share by the book value
per share. A stock could be overvalued if the P/B ratio is higher than one.
Forward P/E
Forward P/E ratio uses the forecasted
earnings per share of the company over the period of next 12 months for
calculating the price-earnings ratio and is calculated by dividing Price per
share by forecasted earnings per share of the company over the period of next
12 months.
The Forward PE Ratio is the projected earnings for
the next year = Projected Earnings per share for the next year / Number of
shares outstanding
Revenue Growth
Revenue is simply the total
sales of a company in a given period. Wall Street demands that essentially
every stock show revenue growth, or at least have a plan to do so in the near
future. While profits are more important to investors, profit growth can be
more volatile and is often influenced by one-time events, making them more
difficult to parse on a quarterly basis. Profit growth can also come from
cost-cutting, which is not always in the best interest of the company's
long-term growth. Revenue growth, on the other hand, is more straightforward
and consistent, and generally gives a clearer reading of a company's growth
prospects.
Dividend Yield
On financial news sites like Yahoo! Finance,
annual dividend payouts are listed alongside percentages called dividend
yields. The yield is the annual dividend payout divided by the stock price.
It's the percentage of the stock's value that investors get paid back to them
each year. The S&P 500's average dividend yield is 1.9%, while the best
dividend-paying stocks pay 4% yields or higher. Note that most stocks pay out
dividends on a quarterly basis, and many stocks don't pay dividends at all.
·
Companies in the utility and consumer staple
industries often having higher dividend yields.
·
Real estate investment trusts (REITs), master
limited partnerships (MLPs), and business development companies (BDCs) pay
higher than average dividends; however, the dividends from these companies are
taxed at a higher rate.
·
Companies in the utility and consumer staple
industries often having higher dividend yields.
·
Real estate investment trusts (REITs), master
limited partnerships (MLPs), and business development companies (BDCs) pay
higher than average dividends; however, the dividends from these companies are
taxed at a higher rate.
·
Companies in the following industry sectors are
observed to be maintaining a regular record of dividend payments:
o Basic materials
o Oil and gas
o Banks and financial
o Healthcare and
pharmaceuticals
o Utilities
Formula:
The dividend yield = amount of money a company pays
shareholders divided by its current stock price.
Market Capitalization
The Market Capitalization is the total equity
value of the company and is found by multiplying the current market price per
share of the company with the total number of outstanding shares excluding the preferred shares.
Outstanding shares are equity shares
since not all shares are part of the company value.
The
market capitalization Formula is the main component when we want to assess a
stock because we can calculate the value of the company from it. The market
capitalization formula gives us the total value of the company.
The
market capitalization Formula allows us to compare companies of a similar
industry. The market divides the stock into three main categories.
a) Small-Cap– Small-cap stocks are
usually start-ups companies that are currently in the development stage. As for
the investors, these usually have small to high-risk
investments. 250 mln – 2 bln.
b) Mid Cap– Investments in mid-cap companies are
usually less risky than the small-cap ones. They have a tremendous scope of
growth and can return a good investment in 3-5 years’ time. 2 bln – 10 bln
c) Large Cap– Large Cap stocks
usually have a safe return as the companies have a good market presence. Min 10
bln
Therefore
market cap formula helps the investors to understand the returns and risks in
the share and also helps them to choose their stock wisely, which fulfills
their criteria of risk and diversification.
We
must also remember that the market cap formula only reflects the equity value of a company.
The enterprise value of the company is a better method as it reflects
debt, preferred
stock.
Enterprise Value
Enterprise Value takes into account
various financial metrics such as market capitalization, debt, (minority interest, preferred
shares), and total cash and cash
equivalents to arrive at the total value of a company. Although
the minority interest and preferred shares are most of the time kept on zero
effectively, this may not be the case for some companies.
In
simple words, enterprise value is the total price of buying a company as it
calculates the accurate value of a company.
The
formula to calculate EV would be;
Enterprise
Value =
market value of common stock or market cap + market value of preferred shares +
total debt (including long and short-term debt) + minority interest – total
cash and cash equivalents.
A company with less or
no debt remains an attractive buy option for investors due to the lower risk
attached to it.
A company with high debt
and less cash carries a higher risk because the debt raises the costs, and
therefore it remains less attractive to investors.
Market Capitalization Debt Cash Enterprise Value
Company A $10
billion $5.0 Billion $1.0 billion $14.0
billion
Company B $10
billion $2.0 billion $3.0 Billion $9.0
billion
A
company with more cash than debt has an enterprise value LESS than Market
Capitalization.
Total Debt to Equity Ratio
Debt
to asset or total equity indicates what proportion of a
company’s assets are being financed with debt rather than equity.
Total debts = Total short term debts +
Total long term debts
Total assets = Total current assets + Total
non-current assets
Total debts / Total assets
It is
important to understand the debt to asset ratio because it is commonly used to
measure debt quantity in a company. It can also be used to assess the debt
repayment ability of a company to check if the company is eligible for any
additional loans. Is that company solvent, will it be able to meet its current
and future obligations, and has the potential to generate a healthy return on
their investment.
A
company with a higher ratio indicates that the company is more leveraged.
Hence, it is considered to be a risky investment. Further, if the ratio of a
company increases steadily, it could be indicative of the fact that a default
is imminent at some point in the future.
If the ratio is equal to
one, then
it means that all the assets of the company are funded by debt, which indicates
high leverage.
If the ratio is greater
than one, then
it means that the company has more debt in its books than assets. It is
indicative of extremely high leverage.
If the ratio is less than one, then it
means that the company has more assets than debts and, as such, has the
potential to meet its obligations by liquidating its assets if required.
Price Earnings Growth (PEG)
Price Earnings Growth
(PEG) ratio is the ratio between price to earnings to the expected growth
rate of a company and it helps in describing the earnings and valuations of the
company.
PEG
Ratio = Price to earnings (P/E) ratio / Growth rate. Or
Price-Earnings ratio (P/E) ratio / Earnings per
share growth rate.
The price-earnings to growth ratio provide you a more refined
look at a prospective value of investment since an irresistibly
high P / E ratio does not inevitably hold up under scrutiny once you take
the growth rate of the company into account.
The price-earnings to growth ratio can provide you a picture that how
costly or cheap a stock of the company is in relation to the rate at which its
earnings are presently rising and the rate at which they are anticipated to
hike over the long-term.
This recommends big merit over computing a Price Earning (P / E) ratio
of a firm individually since that amount only considers the value of the
company in terms of the earnings, which is presently generating.
A lower-Price
Earning Growth ratio usually specifies that business is presently undervalued based
on the performance of its earnings,
Whereas a higher Price Earning
Growth ratio generally specifies that business is presently overvalued.
It means it states that to be fairly valued or price Price Earning Growth ratio
required to be equal to the growth rate of earnings per share or
should be one.
A negative PEG ratio can only mean that either the P/E ratio of the
stock is negative, meaning that the company is losing money or that the
estimated growth rate for future earnings is negative, indicating that the
earnings of the company are expected to decrease in the future.
If the Earnings are negative it throws out the PEG, don’t calculate it
Quick Ratio
Quick Ratio is one of the
most important Liquidity Ratios for determining the company’s ability to pay
off its current liabilities in the short term and is calculated as the ratio of
cash and cash equivalents, marketable securities, and accounts receivables to
Current Liabilities.
Quick
Ratio Formula
Quick Ratio = (Cash & Cash Equivalents +
Short Term Investments + Accounts Receivables) / Current Liabilities
Cash & Cash
Equivalents: Under Cash, the firms include coins & paper money, un-deposited
receipts, checking accounts, and money order.
And under cash equivalent, the organizations take into account money
market mutual funds, treasury securities, preferred stocks which have the
maturity of 90 days or less, bank certificates of deposits, and commercial
paper.
Short Term
Investments: These investments are the short term that can be liquidated easily
within a short period, usually within 90 days or less.
Quick Assets are the ones
that can be converted to cash in the short term or in a period of 90
days. The important difference between the Current Ratio formula and Acid
Test Ratio formula is that we are excluding Inventory & Prepaid
Expenses as a part of Current Assets in the
Quick Ratio formula.
The ratio of 1 or more indicates that the company can pay off its current
liabilities with the help of Quick Assets, and without needing
to the sale of its long-term assets and has sound financial health. Care must
be exercised in placing too much reliance on acid test ratio without further
investigating; e.g., Seasonal businesses
Current Ratio
Current Ratio measures the liquidity of the organization so
as to find that the firm resources are enough to meet short term liabilities
and also compares the current liabilities to current assets of the firm;
Whereas Quick Ratio is a type of liquid ratio which
compares the cash and cash equivalent or quick assets to current liabilities
As an investor, if you want a quick review of how a company is doing
financially, you must look at the current ratio of the company. The current
ratio means a company’s ability to pay off short term liabilities with its
short term assets. Usually, when the creditors are looking at a company, they
look for a higher current ratio; because a higher current ratio will ensure
that they will get repaid easily, and the certainty of payment would increase.
Current Ratio Formula
Current Ratio =
Current Assets / Current Liabilities
As you can see, the current ratio is simple. Just go over to the balance
sheet of the company and select “current assets” and divide the sum by “current
liabilities,” and you get to know the ratio.
Current Assets: Under current
assets, the company would include cash, including foreign currency, short term
investments, accounts receivables, inventories, prepaid expenses, etc.
Current liabilities: Current
Liabilities are liabilities that are due in the next 12 months or less. Under
current liabilities, the firms would include accounts payable, sales taxes
payable, income taxes payable, interest payable, bank overdrafts, payroll taxes
payable, customer deposits in advance, accrued expenses, short term loans,
current maturities of long term debt, etc.
Operating Margin
Operating Profit Margin is the profitability
ratio which is used to determine the percentage of the profit which the company
generates from its operations before deducting the taxes and the interest and
is calculated by dividing the operating profit of the company by its net sales.
We calculate the Operating Profit or Margin
by deducting the cost of goods sold and other operating expenses
from the net sales. And if you look at the income statement of a
company, you would be able to discover the operating earnings quite well. The
specialty of operating income is that it doesn’t include incomes and expenses
except the incomes and expenses related to the operating profit.
The second component in the above operating
margin formula is net sales. We start the income statement with the gross
sales. Gross sales are the total revenue earned by the company. But to find out
the net sales, we need to deduct any sales return or sales discount from the
gross sales.
The formula is:
Operating Margin
Formula = Operating Profit/Net Sales * 100
Shareholder Equity (SE)
For corporations, shareholder
equity (SE), also referred to as shareholders' equity and stockholders'
equity, is the corporation's owners' residual claim on assets after debts have
been paid. Equity is equal to a firm's total assets minus its total
liabilities.
Shareholder
equity can be either negative or positive. If positive, the
company has enough assets to cover its liabilities. If negative, the company's
liabilities exceed its assets; if prolonged, this is considered balance sheet
insolvency.
For this
reason, many investors view companies with negative shareholder equity as risky
or unsafe investments.
Formula:
Shareholders’ equity=total assets−total liabilities
Free Cash Flow vs. Operating Cash Flow
Free cash flow is the cash that a company generates from its
normal business operations after subtracting any money spent on capital
expenditures. Capital expenditures or CAPEX for short, are purchases of
long-term fixed assets, such as property, plant, and equipment.
Operating cash flow is the cash that's generated from normal
business operations or activities. Operating cash flow shows whether a company
generates enough positive cash flow to run its business and grow its
operations.
Operating cash flow tells investors whether a company has enough
cash flow to pay their bills.
Free cash flow tells investors and creditors that
there's enough cash remaining to pay back creditors, pay dividends, and buyback
shares.
Operating Income vs. Net Income
Operating income is a company's profit after deducting
operating expenses which are the costs of running the day-to-day operations.
Operating income, which is synonymous with operating profit, allows
analysts and investors to drill down to see a company's operating performance
by stripping out interest and taxes.
Operating expenses include selling, general & administrative
expense (SG&A), depreciation and amortization, and other operating
expenses. Operating income excludes items such as investments in other firms
(non-operating income), taxes, and interest expenses. Also, nonrecurring items
such as cash paid for a lawsuit settlement are not included. Operating income
is also calculated by subtracting operating expenses from gross profit. Gross
profit is total revenue minus costs of goods sold (COGS).
Net Income is a company's profits or earnings. Net
income is referred to as the bottom line since it sits at the bottom of the
income statement and is the income remaining after factoring in all expenses,
debts, additional income streams, and operating costs. The bottom line is also
referred to as net income on the income statement.
Net income is calculated by netting out items from
operating income that include depreciation, interest, taxes, and other
expenses. Sometimes, additional income streams add to earnings like
interest on investments or proceeds from the sale of assets.
EBITDA Margin, AKA Operating Profitability
EBITDA Margin is a measure of a company's operating
profit as a percentage of its revenue. The acronym stands for earnings before
interest, taxes, depreciation, and amortization. Knowing the EBITDA margin
allows for a comparison of one company's real performance to others in its
industry. An EBITDA-to-sales ratio (EBITDA margin) shows how
much cash a company generates for each dollar of sales revenue, before
accounting for interest, taxes, and amortization & depreciation.
EBITDA (or EBITA or EBIT)
divided by total revenue equals operating profitability.
Calculating a company's EBITDA margin is helpful when gauging
the effectiveness of a company's cost-cutting efforts. The higher a company's
EBITDA margin is, the lower its operating expenses are in relation to total
revenue.
A low EBITDA-to-sales ratio suggests that a
company may have problems with profitability as well as its cash flow, while a
high result may indicate a solid business with stable earnings.
Net Profit Margin
Net Profit Margin (also known as “Profit Margin” or “Net Profit Margin Ratio”) is a financial
ratio used to calculate the percentage of profit a company
produces from its total revenue. It measures the amount of net profit a company
obtains per dollar of revenue gained. The net profit margin is equal to net profit
(also known as net income) divided by total revenue,
expressed as a percentage.
Net Profit Margin Formula
Net Profit margin = Net Profit ⁄ Total revenue
x 100
Return on Assets
Return on Assets
(ROA) is an indicator of how well a company utilizes its assets, by
determining how profitable a company is relative to its total assets.
ROA is best used when comparing similar companies
or comparing a company to its previous performance.
ROA takes into account a company’s debt, unlike
other metrics, such as Return on Equity (ROE).
ROA for public companies can vary substantially and will be highly
dependent on the industry. This is why when using ROA as a comparative measure,
it is best to compare it against a company's previous ROA numbers or against a
similar company's ROA.
The ROA figure gives investors an idea of how effective the company is in
converting the money it invests into net income. The higher the ROA number, the
better, because the company is earning more money on less investment.
Formula:
ROA = Net Income divided by Total Assets
Return on Equity
Return on equity (ROE)
– expresses the percentage of net income relative to stockholders’ equity, or
the rate of return on the money that equity investors have put into the
business. The ROE ratio is one that is particularly watched by stock analysts
and investors. A favorably high ROE ratio is often cited as a reason to
purchase a company’s stock. Companies with a high return on equity are usually
more capable of generating cash internally, and therefore less dependent on
debt financing.
Because shareholders' equity is equal to a company’s assets
minus its debt, ROE is considered the return on net assets. ROE is considered a
measure of the profitability of a corporation in relation to stockholders’
equity.
Return on equity (ROE) measures how the profitability of a
corporation in relation to stockholders’ equity.
Whether an ROE is considered satisfactory will depend on
what is normal for the industry or company peers.
As a shortcut, investors can consider an ROE near the
long-term average of the S&P 500
(14%) as an acceptable ratio and anything less than 10% as poor.
Formula:
ROE = Net Income divided by Stockholders Equity
Sources:
https://www.investopedia.com/terms/c/cyclicalstock.asp
https://www.wallstreetmojo.com/operating-profit-margin-formula/
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