EPS (Earnings-Per-Share) measures how much of a company’s net income actually trickles down to each outstanding share.
Any preferred dividends are first taken out of the net income before calculating EPS.
Interpreting EPS
Earnings Per Share can be used to compare the earnings of two or more companies in a similar industry.
Just because one company makes more money than another, it does not mean that the shareholders are better off.
What matters is how much of the money the company makes actually trickles down to each shareholder and that depends on how many shares there actually are.
If two companies had the same number of shares outstanding, the higher EPS Company would have:
More lucrative earnings.
Higher percentage of earnings going to each share.
Potentially lower preferred dividends paid out.
Similarly, if two companies had the same net income, the higher EPS Company would have:
Fewer shares outstanding.
Shares that have a higher percentage of ownership in the company.
Shares that have a bigger claim to profits than the other company.
Hence, the higher the EPS between two companies in the same industry, the more money each share makes.
Example
Let’s say we wanted to evaluate two companies in the same industry like:
Honda (HMC:NYSE)
and Toyota (TM:NYSE)
Honda’s Net Income after Preferred Dividends: $6,000,000,000 ($6 Billion)
Honda’s Average Outstanding Shares: 1,500,000,000 (1.5 Billion shares)
Toyota’s Net Income after Preferred Dividends: $5,500,000,000 ($5.5 Billion)
Toyota’s Average Outstanding Shares: 1,000,000,000 (1 Billion shares)
At first look, it seems like Honda is the better company as it made more money (Net Income is higher).
But, as a shareholder, when you see how much of that money actually comes down to each share, your decision might change.
PE Ratio (Price-to-Earnings) is a valuation ratio that compares the price per share of a company’s stock to its earnings per share.
It basically shows how much investors are willing to pay for a share given the earnings currently generated.
It is also used to analyze whether a stock is overvalued or undervalued.
Formula
How to use the PE Ratio:
The PE Ratio by itself is just a number and not very useful.
When we compare PE ratios between companies and industries, we really start getting the picture for the particular company we are analyzing.
It does not make much sense to compare PE Ratios of companies across different industries, as each industry has its own unique way of conducting business.
It’s like comparing a doctor with an engineer to see which one is more valuable.
Hence, if comparing PE ratios, they should be compared between companies in the same or similar industries.
You can also compare the PE ratio of a company to the PE Ratio of the entire industry that it operates in to analyze whether the stock is over or under-valued.
How to interpret the PE Ratio
High P/E Ratio may mean:
Market sentiment: An overly optimistic PE Ratio can indicate the market expects big things from this company. The company has high growth possibilities.
Lifecycle: The company could be entering into the Growth or Shake-Out stage of its lifecycle.
Industry: A PE Ratio could be representative of the industry the company is. For example most technology companies have high PE Ratios.
Cover priced or over-bought: A high PE Ratio can indicate a given stock is priced to high and ready for a correction.
This means that it might be over-valued.
Be sure to compare against industry norms.
Low P/E Ratio may mean:
Lack of confidence: A low PE Ratio may indicate a lack of confidence in the future of the company.
Lifecycle: The company could be in the Mature or Decline stage of its lifecycle.
Industry: A PE Ratio could be representative of the industry the company is. For example most utility companies have low PE Ratios.
Sleeper: A low PE Ratio might be a sleeper just waiting to be discovered. This means that it might be undervalued, and a perfect time to start buying the shares.
Example
Coca-Cola and Pepsi operate in the same industry and produce goods that are very similar in nature.
Coca Cola’s (KO:NYSE) stock price (Price per Share): $66
Coca-Cola’s Earnings-per share (EPS): $5.26
Coca-Cola’s PE Ratio: $66 / $5.26 = 12.55
Pepsi’s (PEP:NYSE) stock price (Price per Share): $69
Pepsi’s Earnings-per share (EPS): $3.73
Pepsi’s PE Ratio: ($66 / $5.26) = 18.50
From our calculations, we can see that Pepsi has a higher PE Ratio than Coca-Cola.
This could be perceived a couple of different ways:
Coca-Cola is under-valued and should be bought.
Pepsi is over-valued and should be sold or shorted.
Investors do not perceive Coca-Cola as doing as well as Pepsi presently.
Pepsi is launching a new product that Coca-Cola is not.
The truth is normally some combination of these perceptions.
Over time, and with additional research, one can potentially pinpoint the exact occurrence and make a lot of money by trading according to his or her analysis.
*Important Note*:
The Earnings-Per-Share in the PE Ratio formula is a number that comes from the accounting books of the company.
Hence, it is possible to manipulate the EPS underlying the PE Ratio in order to trick investors into perceiving the stock differently.
It is important to independently verify that the company’s’ financial statements are sound and true.
Conclusion
A PE Ratio is an important valuation tool that can give key insights into whether a stock may be over or under-valued.
Fundamental analysis is the process of looking at the basic or fundamental financial level of a business, especially:
sales
earnings
growth
potential
assets
debt
management
products
competition
This type of analysis examines key ratios of a business to determine its financial health and gives you an idea of the value its stock.
Many investors use fundamental analysis alone or in combination with other tools to evaluate stocks for investment purposes. The goal is to determine the current worth and, more importantly, how the market values the stock.
The Top Down Approach to Fundamental Analysis
Usually fundamental analysis takes into consideration only those variables that are directly related to the company itself, rather than the overall state of the market or technical analysis data but here we are going to describe a top down approach to the typical fundamental evaluation: It starts with the overall economy and then works down from industry groups to specific companies.
As part of the analysis process, it is important to remember that all information is relative. Industry groups are compared against other industry groups and companies against other companies. It is important that companies are compared with others in the same group.
First and foremost in a top-down approach would be an overall evaluation of the general economy. When the economy expands, most industry groups and companies benefit and grow. When the economy declines, most sectors and companies usually suffer. Once a scenario for the overall economy has been developed, an investor can break down the economy into its various industry groups.
If the prognosis is for an expanding economy, then certain groups are likely to benefit more than others. An investor can narrow the field to those groups that are best suited to benefit from the current or future economic environment. If most companies are expected to benefit from an expansion, then risk in equities would be relatively low and an aggressive growth-oriented strategy might be advisable. A growth strategy might involve the purchase of technology, biotech, semiconductor and cyclical stocks. If the economy is forecast to contract, an investor may opt for a more conservative strategy and seek out stable income-oriented companies. A defensive strategy might involve the purchase of consumer staples, utilities and energy-related stocks.
To assess a industry group’s potential, an investor would want to consider the overall growth rate, market size, and importance to the economy. While the individual company is still important, its industry group is likely to exert just as much, or more, influence on the stock price. When stocks move, they usually move as groups
Once the industry group is chosen, an investor would need to narrow the list of companies before proceeding to a more detailed analysis. Investors are usually interested in finding the leaders and the innovators within a group. The first task is to identify the current business and competitive environment within a group as well as the future trends. How do the companies rank according to market share, product position and competitive advantage? Who is the current leader and how will changes within the sector affect the current balance of power? What are the barriers to entry? Success depends on an edge, be it marketing, technology, market share or innovation. A comparative analysis of the competition within a sector will help identify those companies with an edge, and those most likely to keep it.
At this point you will have a shortlist of companies and the final step to this analysis process would be to take apart the financial statements and come up with a means of valuation. Some of the more popular ratios are found by dividing the stock price by a key value driver.
Fundamental Analysis Tools
These are the most popular tools of fundamental analysis. They focus on earnings, growth, and value in the market. For convenience, we have broken them into separate articles.
None of these mean much on their own but when you combine some of them together and adapt your combinations based on the sector the company you’re analyzing is in you will find that they are very good identifying the true value of a stock, thus find you identify the “ticket price” of your potential investment and to determine if your current investments are at or near their full potential…
How to use multiples and ratios to value a company
This methodology assumes that a company will sell at a specific multiple of its earnings, revenues or growth. An investor may rank companies based on these valuation ratios. Those at the high end may be considered overvalued, while those at the low end may constitute relatively good value. But it could also mean that the ones on the low end are “bad companies” and are not worth investing in while the ones on the high end could be very good companies which still have room to grow… Remember that the market is usually right in the long run…
Keep Technical Analysis in mind as well
After all this work you will be left with a handful of candidates and this is where I recommend using technical analysis to develop a trading plan for each one of them. I know investors tend to shy away from technical analysis but this a grave mistake, in my opinion. Knowing how to read charts and understanding that technical analysis is in fact understanding basic human psychology will help you maximize your gains and minimize your losses; how does that sound to you?
Advantages of Fundamental Analysis
Fundamental analysis is good for long-term investments based on long-term trends, very long-term. The ability to identify and predict long-term economic, demographic, technological or consumer trends can benefit patient investors who pick the right industry groups or companies.
Sound fundamental analysis will help identify companies that represent a good value. Some of the most legendary investors think long-term and value. Graham and Dodd, Warren Buffett and John Neff are seen as the champions of value investing. Fundamental analysis can help uncover companies with valuable assets, a strong balance sheet, stable earnings, and staying power.
One of the most obvious, but less tangible, rewards of fundamental analysis is the development of a thorough understanding of the business. After such painstaking research and analysis, an investor will be familiar with the key revenue and profit drivers behind a company. Earnings and earnings expectations can be potent drivers of equity prices. Even some technicians will agree to that. A good understanding can help investors avoid companies that are prone to shortfalls and identify those that continue to deliver. In addition to understanding the business, fundamental analysis allows investors to develop an understanding of the key value drivers and companies within an industry. A stock’s price is heavily influenced by its industry group. By studying these groups, investors can better position themselves to identify opportunities that are high-risk (tech), low- risk (utilities), growth oriented (computer), value driven (oil), non-cyclical (consumer staples), cyclical (transportation) or income-oriented (high yield).
Stocks move as a group. By understanding a company’s business, investors can better position themselves to categorize stocks within their relevant industry group. Business can change rapidly and with it the revenue mix of a company. This happened to many of the pure Internet retailers, which were not really Internet companies, but plain retailers. Knowing a company’s business and being able to place it in a group can make a huge difference in relative valuations.
Disadvantages of Fundamental Analsyis
The main disadvantage for me is that if used on its own, fundamental analysis (FA)doesn’t take into consideration the “herd mentality” phenomenon. In the long run, the price per share (PPS) of companies is driven by their earnings, i.e. the profit they’re yielding. In the short term, the momentum can be quite influential on the PPS: I’m sure you’ve noticed that some stock are considered market darlings and, to a certain degree, it doesn’t matter what their quarterly results are; people keep on buying. The same applies for companies that, all of a sudden, fall out of favor for whatever reason, genuine or not. They keep getting hammered regardless of the results the company pumps out, until one day it reverses… FA doesn’t consider this irrational behavior.
Fundamental analysis may offer excellent insights, but it can be extraordinarily time-consuming. Time-consuming models often produce valuations that are contradictory to the current price prevailing onWall Street. When this happens, the analyst basically claims that the whole street has got it wrong. This is not to say that there are not misunderstood companies out there, but it is quite brash to imply that the market price, and hence Wall Street, is wrong.
Valuation techniques vary depending on the industry group and specifics of each company. For this reason, a different technique and model is required for different industries and different companies. This can get quite time-consuming, which can limit the amount of research that can be performed.
Fair value is based on assumptions. Any changes to growth or multiplier assumptions can greatly alter the ultimate valuation. Fundamental analysts are generally aware of this and use sensitivity analysis to present a base-case valuation, a best-case valuation and a worst-case valuation. However, even on a worst-case valuation, most models are almost always bullish, the only question is how much so.
The majority of the information that goes into the analysis comes from the company itself. Companies employ investor relations managers specifically to handle the analyst community and release information. As Mark Twain said, “there are lies, damn lies, and statistics.” When it comes to massaging the data or spinning the announcement, CFOs and investor relations managers are professionals. Only buy-side analysts tend to venture past the company statistics. Buy-side analysts work for mutual funds and money managers. They read the reports written by the sell-side analysts who work for the big brokers (CIBC, Merrill Lynch, Robertson Stephens, CS First Boston, Paine Weber, DLJ to name a few). These brokers are also involved in underwriting and investment banking for the companies. Even though there are restrictions in place to prevent a conflict of interest, brokers have an ongoing relationship with the company under analysis. When reading these reports, it is important to take into consideration any biases a sell-side analyst may have. The buy-side analyst, on the other hand, is analyzing the company purely from an investment standpoint for a portfolio manager. If there is a relationship with the company, it is usually on different terms. In some cases this may be as a large shareholder.
When market valuations extend beyond historical norms, there is pressure to adjust growth and multiplier assumptions to compensate. If Wall Street values a stock at 50 times earnings and the current assumption is 30 times, the analyst would be pressured to revise this assumption higher. There is an old Wall Street adage: the value of any asset (stock) is only what someone is willing to pay for it (current price). Just as stock prices fluctuate, so too do growth and multiplier assumptions. Are we to believe Wall Street and the stock price or the analyst and market assumptions? It used to be that free cash flow or earnings were used with a multiplier to arrive at a fair value. In 1999, the S&P 500 typically sold for 28 times free cash flow. However, because so many companies were and are losing money, it has become popular to value a business as a multiple of its revenues. This would seem to be OK, except that the multiple was higher than the PE of many stocks! Some companies were considered bargains at 30 times revenues.
What have we learnt?
To conclude, fundamental analysis can be valuable, but it should be approached with caution. If you are reading research written by a sell-side analyst, it is important to be familiar with the analyst behind the report. We all have personal biases, and every analyst has some sort of bias. There is nothing wrong with this, and the research can still be of great value. Learn what the ratings mean and the track record of an analyst before jumping off the deep end. Corporate statements and press releases offer good information, but they should be read with a healthy degree of skepticism to separate the facts from the spin. Press releases don’t happen by accident; they are an important PR tool for companies. Investors should become skilled readers to weed out the important information and ignore the hype.
Class B Shares are a form of common stock that may have more or less voting rights that Class A shares. Generally Class B shares have lesser voting rights, but be vary of some companies that trick investors by using the perception of Class “B” (compared to “A”) shares to attach more voting rights to them than Class A shares.
A Covered Call Strategy is for investors who feel that the stock price will either remain stable or will grow. This strategy is NOT for investors who think the price of the stock will go down.
How do I execute this strategy?
The strategy entails two steps:
Write a call option
Buy the appropriate number of underlying stocks
How does a Covered Call work?
The reason the strategy is called a “covered” call is because the call option that is written is “covered” by the underlying stock in case the person on the other side of the option exercises it.
The best way to explain how the covered call works is to use an example.
Let’s say we are using Bank of America (BAC:NYSE) to write a covered call.
Remember, for a covered call, you write the option and you buy the stock:
Write one $15 call option (Option multiplier is 100): $2.50 X 100 = $250 Inflow
Buy 100 shares of the underlying stock to cover the written call option: $10 X 100 = -$1,000 Outflow
Scenario 1: After one month, the option expires and the price of BAC has doubled to $20
Chances are that the $15 Call Option you wrote would get exercised. This means that you HAVE to sell your underlying stocks for $15.
Your inflow: $15 X 100 shares = $1,500
By putting together your total inflows and outflows, we get:
1,500 + 250 – 1,000 = $750
That’s great!! You made $750!!!
Scenario 2: After one month, option expires and the price of BAC remains the same at $10
Chances are that your option will not get exercised.
You can choose to keep or sell the underlying stock. Lets say you decide to sell it.
Your inflows will be: $10 X 100 share = $1,000
You are better off by:
$1,000 + $250– $1,000 = $250
That’s still great! You made $250!
Scenario 3: After one month, option expires and the price of BAC has dropped to $5
Your option will definitely not get exercised. But the stock that you hold has dropped in value. Lets see how badly it has affected your strategy.
If you sell your stock, your inflows will be: $5 X 100 shares: $500
You are worse off by:
$500 + $250– $1,000 = -$250
That’s not good. You just lost $250 from your own pocket.
Visualize This
You can see what effect the price of the BAC stock has on the overall profit /loss of the covered call strategy below:
Another use of the Covered Call strategy
The covered call strategy is also used as a form of hedging or insurance by investors. These investors are banking on the price of the stock to go down, but want to feel safe in case the price turns against them.
This is different to the way covered call is used in the example above as the goal for that was to make money from an option exercise. The goal for this strategy is to cut your losses if the market turns against you.
Keep in Mind
A covered call is a better option than writing a naked call option, even though it might cost more up front to purchase the underlying stock.
Margin Requirements are lower than for writing a naked option as you are covered incase the market moves against you.
While the maximum amount of money you can make with this strategy is limited, the chances that you will make money becomes greater for you if you find the right option to write at a favorable strike price. For more information about writing call options, visit an introduction to writing call options.
Like anything you invest in, careful analysis is key.
Class A Shares are a form of common stock that may have more or less voting rights that Class B shares. Generally Class A shares have more voting rights, but companies sometimes trick investors by using the perception of “Class A” shares to attach fewer voting rights to them than Class B shares.
Balanced Fund is a type of Mutual Fund whose main objective is to diversify risk by holding a defined percentage of different security types including stocks, bonds, and money market instruments
The American Stock Exchange is the third largest Stock Exchange in the US by trading volume. It overlooks the trading of approximately 10% of all US traded securities including small-cap stocks, ETF’s and Derivatives.
An Aggressive Growth Fund is a form of Mutual Fund whose main investment objective is to achieve capital gains. These funds are perceived to generate high returns, and are catered to investors who have a high tolerance for risk.
