The Formula For Computing Earnings Per Share Is Net Income Stock Market – How to Use Fundamental Analysis to Make Trading Decisions

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Stock Market – How to Use Fundamental Analysis to Make Trading Decisions

Inventory analysis

Investors come in all shapes and forms, so to speak, but there are two basic types. The first and most common is the more conservative type who picks a stock by looking at and studying the company’s fundamental value. This belief is based on the assumption that as long as the company is well managed and continues to make a profit, the share price will rise. These investors seek to buy growth stocks that appear most likely to continue growing for longer periods of time.

Another, but less common, type of investor tries to gauge how the market might behave based purely on the psychology of people in the market and other similar market factors. Another type of investor is more commonly referred to as a quant. This investor expects the stock price to skyrocket as buyers bid back and forth (often regardless of the stock’s value), similar to an auction. They often take much higher risks with higher potential returns, but have a much higher chance of taking bigger losses if they fail.

Fundamentalists

Investors must consider many factors to find the intrinsic value of a stock. If a stock’s price is in line with its value, it has achieved the goal of an “efficient” market. Efficient market theory states that stocks are always correctly valued because everything publicly known about a stock is reflected in its market price. This theory also suggests that analyzing stocks is pointless because all known information is reflected in the current price. Simply put:

  • The exchange sets the prices.
  • Analysts weigh known information about a company and thereby determine a value.
  • Price does not have to equal value. The efficient market theory is, as the name suggests, a theory. If this were the law, prices would instantly adjust to information as it became available. Since it is theory instead of law, it is not. Stock prices move above and below company values ​​for both rational and irrational reasons.

Fundamental analysis attempts to determine the future value of a stock by analyzing the current and/or past financial strength of a particular company. Analysts try to determine whether a stock’s price is above or below value and what that means for the future of that stock. Many factors are used for this purpose. The basic terminology that helps an investor understand the analysts’ decision is as follows:

  • “Value stocks” are those below market value and include bargain stocks valued at 50 cents on the dollar.
  • “Growth stocks” are those whose primary consideration is earnings growth.
  • “Income stocks” are investments that provide a steady source of income. This is primarily through dividends, but bonds are also common investment vehicles used to generate income.
  • “Momentum Stocks” are growth companies currently entering the market picture. Their stock prices are rising rapidly.

All of the following factors must be considered in order to make fundamental decisions. Prior terminology is a determining factor in how they are used based on investor preconceptions.

1. As usual, the revenue of a particular company is the main deciding factor. A company’s profit is profit after taxes and expenses. Stock and bond markets are primarily driven by two powerful dynamics: earnings and interest rates. There is often stiff competition for cash flows into these markets, moving into bonds as interest rates rise and stocks as earnings rise. More than any other factor creates the value of a company’s earnings, although there are other caveats to this idea.

2. EPS (Earnings Per Share) is defined as the reported amount of earnings per share that a company has at any given time to pay dividends to common shareholders or to reinvest in itself. This company health indicator is a very powerful way to predict the future of a stock’s price. Earnings per share is arguably one of the most widely used key metrics.

3. The fair price of a share is also determined by the P/E (price/earnings) ratio. For example, if a particular company’s stock is trading at $60 and its EPS is $6 per share, its P/E is 10, meaning investors can expect a 10% return on cash flow.

Equation: $6/$60 = 1/10 = 1/(PE) = 0.10 = 10%

Similarly, if it earns $3 per share, its multiple is 20. In this case, the investor could get a 5% return if current conditions remain the same in the future.

Example: $3/$60 = 1/20 = 1/(P/E) = 0.05 = 5%

Certain industries have different P/E ratios. For example, banks have low P/Es, typically between 5 and 12. High-tech companies, on the other hand, have higher P/E ratios, typically around 15 to 30. On the other hand, in the not-too-distant past , Internet stocks saw triple-digit P/E ratios. These were stocks with no earnings, just a high P/E ratio that defied theories of market efficiency.

A low P/E does not indicate accurate value. The first thing to consider is the price movements, range, direction and notable news related to the stock. An investor must also consider why any P/E is low. P/E is best used to compare companies in a similar industry.

The The Ladies of Beardstown recommends that any P/E below 5 and/or above 35 be scrutinized for error as the market average is historically between 5 and 20.

Peter Lynch suggests comparing the P/E ratio to the company’s growth rate. Lynch considers stocks to be fairly priced only when they are roughly equal. If it’s less than the growth rate, it could be a stock trade. For perspective, the basic idea is that a P/E ratio that is half the growth rate is very positive and twice the growth rate is very negative.

Other studies show that a stock’s P/E ratio has little influence on the decision to buy or sell stocks (William J. O’Neal, founder of Investors Business Daily, in his research on successful stock movements). Still, the stock’s current earnings record and year-over-year earnings growth are vital, he says.

It should be mentioned that P/E and/or Earnings per Share are useless to investors before buying shares. The money is made after the shares are bought, not before. Therefore, the future will pay off in both dividends and growth. This means that investors need to pay as much attention to forecasts of future earnings as they do to the historical record.

4. The basic PSR (price-to-sales ratio) is similar to the P/E ratio, except that the stock price is divided by sales per share rather than earnings per share.

  • For many analysts, PSR is a better measure of value than P/E. This is because earnings often fluctuate wildly, while sales tend to follow more reliable trends.
  • PSR can also be a more accurate measure of value because sales are more difficult to manipulate than income. The credibility of financial institutions has suffered from the failure of Enron/Global Crossing/WorldCom and others, and investors have learned how manipulation works at large financial institutions.
  • PSR by itself is not very effective. It is only used effectively in conjunction with other measures. In his book What Works on Wall Street, James O’Shaughnessy found that when PSR is used as a measure of relative strength, it becomes the “king of value factors.”

5. The debt ratio shows the percentage of a company’s debt compared to shareholders’ equity. In other words, how much the company’s operations are financed with loans.

  • Remember that less than 30% is positive, more than 50% is negative.
  • A successful operation with increasing profitability and a well-marketed product can destroy a company’s debt load, as revenue is sacrificed to pay off debt.

6. ROE (Equity Returns) is found by dividing net income (after taxes) by owner’s equity.

  • ROE is often considered the most important financial ratio (for shareholders) and the best measure of a company’s management capabilities. ROE gives shareholders the confidence they need to know that their money is well managed.
  • ROE should always increase every year.

7. The Price/Book Ratio (aka Market/Book Ratio) compares the market price of a stock to its book value per share. This ratio relates to what investors believe the company (stock) is worth, according to the company’s accountants, according to generally accepted accounting principles. For example, a low ratio indicates that investors believe that the company’s assets are overvalued based on its financial statements.

Although investors would like stocks to trade at the same time as book value, in reality most stocks trade either at a premium or a discount to book value.

Stocks trading at 1.5x to 2x book value are about the limit when looking for value stocks. Growth stocks justify higher ratios because they allow you to expect higher returns. Stocks that are below book value would be ideal at a wholesale price, but this rarely happens. Companies with low book value are often takeover targets and investors tend to avoid them (at least until the takeover is completed and the process begins again).

Accounting was more important at a time when most industrial companies had actual hard assets, such as factories, to back up their inventory. Unfortunately, the value of this measure has diminished as small-cap companies have become commercial giants (ie Microsoft). Videlicet, look for a low book value to keep the data in perspective.

8. Beta compares a stock’s volatility to that of the market. Beta 1 assumes that the price of the stock moves up and down at the same rate as the market in general. A beta of 2 means that if the market goes down, the stock is likely to double. A beta of 0 means it doesn’t move at all. A negative beta means that it moves in the opposite direction to the market, which means a loss for the investor.

9. Capitalization is the total value of all outstanding shares of a company and is calculated by multiplying the market price of a share by the total number of outstanding shares.

10. Institutional ownership refers to the percentage of a company’s outstanding shares owned by institutions, mutual funds, insurance companies, etc., which move in and out of positions in very large blocks. Some institutional ownership can actually provide stability and contribute to a list of stocks with their buying and selling. Investors find this an important factor because they can take advantage of the extensive research done by these institutions before making their portfolio decision. The importance of institutions in market activity cannot be overstated and they account for over 70% of the dollar volume traded each day.

Market efficiency is always the goal of the market. Anyone who puts money into stocks wants to see a return on their investment. Nevertheless, as mentioned above, the market is always driven by human emotions, which cause common stocks to be overvalued and undervalued. Investors need to use patterns using modern computational tools to find the most undervalued stocks and develop the right response to these market patterns, such as moving in a channel (trend recognition) smartly.

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