Fundamental Analysis and the five main ratios
Fundamental analysis also known as quantitative' analysis involves the detailed analysis of financial statements to assess how a company may perform in the future. Fundamental analysis is not qualitative analysis, i.e., it does take account of the intangible and hence hard-to-measure aspects of a company's operations such as the value of its goodwill, the value of any brands it may own and other intangibles. Neither does fundamental analysis encompass technical analysis where decisions to trade are based solely on a share's price and volume movements. Fundamental analysis uses real, hard data to ascertain a share's real (intrinsic) worth by examining revenues, earnings, future growth, return on equity, profit margins and other data. When positive' anomalies are found i.e. a company's share appears undervalued, then the investor may consider buying in.
Investors who depend solely on fundamental analysis (Value Investors) will normally use at least five key ratios to decide whether a share represents good value or not. For these ratios to be meaningful, the comparisons should be between i) similar entities in similar sectors or industries and ii) well established businesses as distinct to start ups, or businesses in other special circumstances.
Price-to-Earnings Ratio (P/E)
One of the best-known and most valuable of the five key ratios. P/E compares a company's current share price with its past (trailing P/E) or potential earnings (forward P/E) per share. If, for example, a company's share price is currently 10 a share and the earnings over the last 12 months (a trailing P/E) were 0.50p a share, then the P/E ratio would be a value of 20 (10 divided by 0.50p). Assuming the financial performance of two companies is almost identical, then the company with the lowest P/E ratio costs less per share for the same financial outcome than the one with the higher P/E.
Price-to-Book Ratio (P/B)
The P/B indicates the amount investors are willing to pay for a share of the company's tangible assets, which by definition excludes intangible assets such as goodwill. The investor must first know the book value of all the company's fixed and current assets minus its current and long-term liabilities values which can be obtained from the balance sheet. The ratio is calculated by dividing the total value of the assets by the total number of issued shares. If the resultant ratio is less than 1, it would mean that shares can be bought in that company for less than the book value of its assets.
Debt-to-Equity Ratio (D/E)
The D/E ratio also known as Gearing' indicates what proportion of shareholders' funds (and some other types of debt such as loans or bonds) are being used to finance the assets of the business. It can also indicate how much money a company can safely afford to borrow over the long term. To determine the D/E ratio, the company's total long term debt is divided by shareholders equity. If a company has total debts of 1,000,000 and shareholder's equity of 4,000,000 then the debt/equity ratio would be 0.25 (1,000,000 divided by 4,000,000). Where the ratio is higher than 100 the majority of the company's assets are financed through debt: if the ratio is less than 100, then the assets are financed mainly through equity.
Free Cash Flow (FCF)
Free cash flow measures how much money a company has left over after paying its overheads and taxes, making any capital investments and covering its working capital requirements. Knowing the FCF is particularly important to shareholders as it shows the amount of money that's available for dividend payments. FCF also enables the business to buy back shares, reduce or eliminate debt and invest in plant and equipment. The ratio is calculated by subtracting non-discretionary costs such as capital expenditure from the company's operating cash flow and then dividing that figure by the company's market capitalisation and total debt. Strong companies usually show positive free cash flow and the higher the FCF ratio, the better.
The price to earnings growth ratio (PEG)
This is an extended version of the P/E ratio as it takes earnings growth into account. PEG compares a company's P/E ratio to its earnings growth rate to determine whether the shares are undervalued or overvalued. The ratio is calculated by dividing a share's P/E ratio by its projected year-over-year earnings growth rate. So if for example the company's earnings per share the previous year were 15p and projected earnings per share this year are 18p that represents an earnings growth rate of 20%. On that basis if the company's P/E ratio were 30 then the PEG would be 1.5 i.e. 30/20 suggesting that the shares may be overvalued by as much as 50%. Conversely, and as a rule of thumb only, a PEG of less than 1.might suggest the shares are cheap. Generally speaking, the lower the PEG, the better the value, because each module of earnings growth costs the investor less.