Fundamental Analysis: Financial Statements
Financial statements can sometimes scare off investors with the unbelievable amount of information given. Though if you can get over your intimidations and learn how to analyze financial statements it can be a gold mine of info. Financial Statements are the way a company discloses all its numbers. Investors use the quantitative information given from financial statements to make investment decisions. Before we learn all the ins and outs it is crucial we learn the three most important statements: Income Statement, Balance Sheet, Cash Flow Statement.
Represents company’s assets, liabilities, and equity at a certain time. If you ever studied accounting you should know the following formula:
Assets = Liabilities + Shareholder’s Equity
Assets are crucial factors as they show the resources and capital your business owns and controls. Assets are comprised of everything from cash, inventory, machinery, etc. Financing comes as a result of both liabilities and equity. Liabilities are how much debt you have and equity represents the total value of money that owners have contributed.
Income statement represents how much money a company has been making in a specific period of time. It’s a good indicator to analyze a company’s performance.
Statement of Cash Flows
Shows how much cash is being generated and coming through the business. Cash inflows and outflows are crucial in balancing the company’s budget. The Statement of Cash Flows is a conservative way to measure a company’s performance, as unlike earnings there is no way to manipulate cash in hand.
Price of Stock
Earnings per Share
The P/E Ratio tells us how much an investor is willing to pay for $1 of company earnings. Usually the long-term average P/E is around 15 so basically investors are willing to pay $15 per dollar of earnings. When comparing P/E its important to consider the difference between industries. Industries with higher risks will usually attract lower P/E Ratios. Another way to use the P/E Ratio is by turning it around to look at the E/P Ratio. Look at it this way, for $1 earnings per $15 it expresses an E/P of 1/15, which gives an earnings yield of 6.67%. At the end, the P/E Ratio should roughly mimic the EPS for value based-growth stocks. Now a days most stocks with low P/E Ratios have bad times ahead. This speaks for the majority, not to say there are not still value stocks out there with low P/E’s but usually they are backed by other strong fundamental indicators.
Market Cap (Shares Outstanding x Market Price Per Share)
The P/S comes in as a good indicator when valuing both young up and coming companies and unprofitable companies which do not have a P/E Ratio. For value investors a P/S under 1 shows an opportunity. It is also worth considering that a relatively low P/S ratio with a rising stock price to be a good basis to invest in growth stocks that have suffered a setback. Look at the P/S for the past 10 years; if it is below the average it could be a good indicator of value. A P/S above 10 is momentum priced. Only buy momentum priced stocks in a strong market.
Forecast Earnings Growth
The PEG Ratio takes the annualized rate of growth out of any further estimates. Further growth adds to the value of a company thereby it makes sense that higher growth rates will increase a companies value. Relying on just the P/E ratio is misleading. Take this for example: If a company is expected to grow 15% a year over the next two years and has a P/E of 15 then it will have a PEG Ratio of 1. Whereas a company with a P/E of 10 and expected growth of 20% would have a PEG Ratio of 0.5. Last if a company had a P/E of 20 and a growth of 10% it would have a PEG Ratio of 2. All in all, the lower the companies PEG Ratio, the more cheaply valued it is. Use this following chart when analyzing companies PEG Ratios:
Under 1 = Undervalued Companies
Equal 1 = Value Companies
Over 1 = Overvalued Companies
Overall the PEG Ratio is a good indicator in analyzing growth companies.
Now that we have gone through the Fundamental Factors lets take a look at the Technical Factors