Investing is something of a fluid concept. To invest successfully requires you to master a challenging mix of scientific concepts, subjective judgements and even a little dash of best guess predictions about the future fate of the economy, specific sectors and individual companies themselves.
You need to be a scientist, pragmatist and mystic all rolled into one. It can get tense. Perhaps even frustrating. It’s never, ever dull.
Right now, it’s time to don your scientist hat, because we’re going to discuss Fundamental Analysis.
Fundamental analysis is quite possibly the most important skill you’ll need to develop as an investor:
Fundamental analysis is the use of mathematical formulas applied to the company’s financial and other data to assess the strength of a company across many different disciplines. Fundamental analysis uses data from the company’s Profit & Loss, Balance Sheet & Cashflow statements.
Long term investors always look at fundamental analysis first, and accredit fundamental analysis with by far the heaviest weighting when it comes to making investment decisions between different stocks.
If you’re tensing up at the idea of wading through hundreds of different company statements, then relax – because most of the fundamental analysis you’ll ever need to use to assess a stock is available freely on the internet, and already calculated for you. All you need to do is understand what the numbers mean, and that’s what you’ll learn next.
The most important part of fundamental analysis is what’s known as the KEY RATIOS. The total number of different ratios that exist are practically encyclopaedic, and here are a few of the features of a company that they measure:
• Underlying profitability of the stock
• How comfortable the cashflow of the stock is
• The earnings growth of the stock
• How the stock price has grown over the years
• How hard the assets of the company are working
• How highly leveraged the stock is
Let’s now look at each of the most popular ratios you’ll want to use when weighing up whether to invest in a stock or not:
Earnings Per Share (EPS)
EPS is possibly the most quintessential of the ratios. I would venture to wager that the first time a ratio was calculated, EPS was it. Because, it reveals the most crucial thing that investors want to know about. What each unit of stock will earn them!
EPS = Net Earnings / Total Number Of Shares Outstanding
You don’t need to worry too much about actually calculating the ratio, free sites like Yahoo Finance (and others) will have these ratios calculated for you. Rather, understand the essence of what the numbers mean, and why they are so important.
For example, let’s say company A has $100 in earnings and 10 shares outstanding – the EPS would be:
100/10 = 10
Let’s now say company B has net earnings of $200 and has 100 shares outstanding. The EPS for company B would be:
200/100 = 2
Do you see that while company B has higher net earnings than company A, the earnings per share for company A is MUCH higher. This quite nicely illustrates why understanding and applying ratios are so very important to investors. They allow you to drill right down into how potent an investment may be.
This example also nicely highlights one other thing about ratios – they are comparison tools. A ratio calculated in isolation does not really tell us anything. Only by comparing the ratio against the same ratio for other companies, or sector averages do we really learn anything about the stock.
Start playing about with the EPS – get your hands dirty and see how markedly different the EPS for various companies are.
While the EPS is indeed the President of the nation of ratios, it cannot be used in isolation. Using it alongside the other key ratios will help you get a better understanding of whether the stock you’re analyzing is likely to fly , or drown haplessly – taking your money with it.
