Fundamental Analysis

Many opinions are expressed about technical analysis versus fundamental analysis. If one feels more comfortable with the fundamentals, one might say that technical analysis is only the past performance of a financial instrument and the only way to try to predict its future performance is to fundamentally analyze it. On the other hand, if you ask the technicians, they will say that all past and current information is reflecting, and will reflect, its future performance; all that is required is to read its performance output with several technical analysis tools to predict in a rather accurate its near future behavior.

The truth is somewhere in the middle. Fundamental analysis can analyze a financial instrument with up to a certain degree of precision. Today, firms are multinational, multicurrency, with many divisions and sub-divisions, and it almost impossible to cope.

A good and sad example is Enron. This corporation was one of the world's leading electricity, natural gas, pulp and paper, and communications companies, with claimed revenues over $100 billion. The finest analysts in the market covered Enron, but few suggested the there something wrong with this huge corporation. Finally, the corporation exposed that it reported its financial condition with a creatively and well-planned accounting fraud.

To be able to see a broader and more comprehensive picture you need to understand the fundamentals as well. You are not required to become an analyst, but you need to understand the instrument you are dealing with, its history performance, and what will influence its future price action.

Let us take first a corporation traded on the exchanges. Several key financial terms will guide you as an unprofessional analyst to understand a corporation's financial state.

First we will look at ratios. Published on almost any financial website, the multipliers are the corporation financial strength indicators and you should consider them relative to other corresponding corporations in the same sector and/or the same product line or services.

We should know the following financial terms: EPS, market capitalization, beta, institutional holdings rate and dividend yield, ratios, P/E, F P/E.

Of course, there are more financial terms but it is enough for us to understand whether this corporation is holding up with the rest of its competitors in the same sector: is it lagging behind or a frontrunner? As you already know, corporate managers can manipulate their financial reports, and management tends to minimize fouls and cover them with good news.

Nevertheless, if we agree that most of them will unveil the real picture, then it is okay for us to analyze with these key financial terms.

Market capitalization is the number of outstanding shares multiplied by the share price. For example, for Google (GOOG) if the amount of outstanding shares is 315 million and the stock price is $371, its market capitalization $116.86 billion.
These numbers will reveal if this corporation is a small-cap, mid-cap, or large-cap, and you will see what pricing is suitable for each of the three capitalizations.

Institutional holdings rate differentiates the company from other companies by how well it is open and transparent, also the fact that if large institutions buy this company’s stock it signifies that this company passed a due diligence and it is okay to consider trading this stock. The higher the rate the better, more and more institutions are interested in this company and of course "strong hands or deep pockets" are holding this stock for the long run and probably you will encounter higher liquidity.

Beta is a measure of a stock volatility in relation to the rest of the market and its equivalence is 1.0.  i.e., if stock’s beta is 1.0 it indicates that its price is as volatile as market's fluctuations. A higher beta indicates greater volatility and a lower beta indicates less volatile movement. In practical terms, beta is used to gauge the risk/return of a financial instrument; higher values equate to greater risk and potential returns relative to the overall market. A security's difference in beta value from 1.0 can be thought of as a percentage of volatility, with a stock posting a beta of 1.5 being 50% more volatile than the market and a stock posting a beta of 0.6 being 40% less volatile than the market.  The investor should consider a financial instrument’s beta among other important guidelines.

For example, when planning a strategy that will benefit from a sharp move, one should consider a beta higher than 1.8, and if one wants to hedge he or she should pick financial instrument as close to zero as possible. A negative beta indicates that financial instruments movement inverse to the markets.

One good example is iShares Barclays 20+ Year Treasury Bond Fund (TLT) (formerly iShares Lehman 20+ Year Treasury Bond Fund). TLT seeks to approximate the total rate of return of the long-term sector of the United States Treasury market as defined by the Barclays Capital 20+ Year US Treasury Index. The Index measures the performance of public obligations of the United States Treasury that have a remaining maturity of 20 or more years, are rated investment grade and have $250 million or more of outstanding face value. In addition, the securities must be denominated in United States dollars, and must be fixed-rate and non-convertible securities. TLT represents 20+ treasury bonds reacts in opposition to main market movement. When market participants start to perceive a future negative momentum in the market, they sell their stocks of course this action puts pressure on the market and the subsequent action is to ‘park the money’, buy bonds and gain from their yield. This action of course elevates bond’s prices and reduces its yields.

EPS (earning per share): Calculated on quarterly basis and calculated yearly or total-trailing twelve months net income divided by the outstanding shares.

For example, a corporation’s net quarterly income is $250M and outstanding 399M shares, the EPS will be 250/399, about $0.63 per share. Usually, if you want to estimate yearly net income per share, a common way to do so is to multiply the last quarterly EPS by 4 for the total next year, say $0.63 per share times 4, about $2.52 per share.

P/E (price earnings ratio):  A stock's price divided by its yearly earnings (always calculated on yearly or total trailing twelve months basis). Supposing that stocks price is $56.00 and its EPS is $2.52, then its P/E will be 56/2.52, about $22.00.

Well, what does this number say? First, it says that your return on investment will be over 20 years. If you pay $56.00 for a stock it also says that you bought a part of this public corporation and a full return on your investment will be in 22 years, $56 divided by its current yearly estimated EPS $2.52 equals to 22 years. This number will say nothing if we will not compare it to the corresponding corporations that acts in the same sector.

F P/E (future price earnings) are usually estimations stemming from the corporate management guidance, or analyst's estimations. Calculating the future P/E, will give us estimation, whether the current price is cheap or expensive, in relation to its standards. Let us say, a stock usually trades at 22-price earnings ratio. According to is future price earnings ratio, the new figure will be 18, this means, the stock is relatively cheap and worth buying, or, on the other hand, if its future price earnings ratio is 27, this means that future earnings will deteriorate and it's time to sell the stock and move on to a better priced stock.

For example, in the communication services sector there are two major corporations active in the same market. AT&T Inc. (T) is a provider of telecommunications services in the United States. The services and products that it offers vary by market, and include wireless communications, local exchange services, long-distance services, data/broadband and Internet services, video services, telecommunications equipment, managed networking, wholesale services and directory advertising and publishing. Its traditional Wire line local exchange subsidiaries operate in 22 states.  

The other corporation, Verizon Communications Inc. (Verizon) (VZ) is engaged in providing communication services. The two segments of the Company are Wire line and Domestic Wireless. Wire line communications services include voice, Internet access, broadband video and data, next generation Internet protocol (IP) network services, network access, long distance and other services. The Company provides these services to consumers, carriers, businesses and government customers both domestically and internationally in 150 countries. Domestic Wireless products and services include wireless voice, data products and other services, and equipment sells across the United States. 

Now if you compare these two corporations will see that they have almost identical lines of products and activities and because of that, their price earnings ratio should be equal. Market data shows, valid as of February 9 2009, AT&T priced at price earnings ratio of 12 and its future price earnings ratio of 14. Verizon priced at price earnings ratio of 14 and its future price earnings ratio of 16.

Through rough times, both corporations are influenced by market conditions in a same manner. How we are benefiting from these findings? If one wants to trade a corporation that acts in the above line of business, he or she should consider the ‘gorillas’ ratio pricing, meaning; if he or she wants to trade a smaller corporation, its ratio would be higher than these mature corporations. Two scenarios are valid: scenario one, this corporation is in a very bad situation and it is rationale to short trade, scenario two, this corporation is undervalued and rational to long trade. Either way, reading this signal, one should go to corporations financial news and see which one of scenarios is valid and reason his or her actions.

Dividend yield: The yield a company pays out to its shareholders in a form of dividends. Mature, well-established companies usually tend to pay higher dividend, while young or growth-oriented companies tend to have lower dividends, most small growing companies do not pay dividends at all.
Calculating the dividend yield: summing the paid dividends per share over the course of a year and dividing by the stock's price. For example, if a stock pays out $5 in dividends over the course of a year and trades at $50, then it has a dividend yield of 10%.