Valuation Methods Used in Fundamental
Analysis of Stocks
By: InvestorGuide Staff, dated January 25th, 2013 with pictures added by Mr. B
Fundamental analysis is a method used to determine the value of a stock by analyzing the
financial data that is ‘fundamental’ to the company. That means that fundamental analysis takes
into consideration only those variables that are directly related to the company itself, such as its
earnings, its dividends, and its sales. Fundamental analysis does not look at the overall state of
the market nor does it include behavioral variables in its methodology. It focuses exclusively on
the company’s business in order to determine whether or not the stock should be bought or sold.
Warren Buffet
"It's far better to buy a wonderful company at a fair price than a fair company at a wonderful price."
Critics of fundamental analysis often charge that the practice is either irrelevant or that it is
inherently flawed. The first group, made up largely of proponents of the efficient market
hypothesis, say that fundamental analysis is a useless practice since a stock’s price will always
already take into account the company’s financial data . In other words, they argue that it is
impossible to learn anything new about a company by analyzing its fundamentals that the market
as a whole does not already know, since everyone has access to the same financial information.
The other major argument against fundamental analysis is more practical than theoretical. These
critics charge that fundamental analysis is too unscientific a process, and that it’s difficult to get
a clear picture of a company’s value when there are so many qualitative factors such as a
company’s management and its competitive landscape.
However, such critics are in the minority. Most individual investors and investment professionals
believe that fundamental analysis is useful, either alone or in combination with other techniques.
If you decide that fundamental analysis is the method for you, you’ll find that a company’s
financial statements (its income statement, its balance sheet and its cash flow statement) will be
indispensable resources for your analysis . And even if you’re not totally sold on the idea of
fundamental analysis, it’s probably a good idea for you to familiarize yourself with some of the
valuation measures it uses since they are often talked about in other types of stock valuation
techniques as well.
Earnings
It is often said that earnings are the “bottom line” when it comes to valuing a company’s stock,
and indeed fundamental analysis places much emphasis upon a company’s earnings. Simply put,
earnings are how much profit (or loss) a company has made after subtracting expenses. During a
specific period of time, all public companies are required to report their earnings on a quarterly
basis through a 10-Q Report . Earnings are important to investors because they give an indication
of the company’s expected dividends and its potential for growth and capital appreciation. That
does not necessarily mean, however, that low or negative earnings always indicate a bad stock;
for example, many young companies report negative earnings as they attempt to grow quickly
enough to capture a new market, at which point they’ll be even more profitable than they
otherwise might have been. The key is to look at the data underlying a company’s earnings on its
financial statements and to use the following profitability ratios to determine whether or not the
stock is a sound investment.
Warren Buffet
"If a business does well, the stock eventually follows."
Earnings Per Share
Comparing total net earnings for various companies is usually not a good idea, since net earnings
numbers don’t take into account how many shares of stock are outstanding (in other words, they
don’t take into account how many owners you have to divide the earnings among). In order to
make earnings comparisons more useful across companies, fundamental analysts instead look at
a company’s earnings per share (EPS). EPS is calculated by taking a company’s net earnings and
dividing by the number of outstanding shares of stock the company has. For example, if a
company reports $10 million in net earnings for the previous year and has 5 million shares of
stock outstanding, then that company has an EPS of $2 per share. EPS can be calculated for the
previous year (“trailing EPS”), for the current year (“current EPS”), or for the coming year
(“forward EPS”). Note that last year’s EPS would be actual, while current year and forward year
EPS would be estimates.
P/E Ratio
EPS is a great way to compare earnings across companies, but it doesn’t tell you anything about
how the market values the stock. That’s why fundamental analysts use the price-to-earnings
ratio, more commonly known as the P/E ratio, to figure out how much the market is willing to
pay for a company’s earnings. You can calculate a stock’s P/E ratio by taking its price per share
and dividing by its EPS. For instance, if a stock is priced at $50 per share and it has an EPS of $5
per share, then it has a P/E ratio of 10. (Or equivalently, you could calculate the P/E ratio by
dividing the company’s total market cap by the company’s total earnings; this would result in the
same number.) P/E can be calculated for the previous year (“trailing P/E”), for the current year
(“current P/E”), or for the coming year (“forward P/E”). The higher the P/E, the more the market
is willing to pay for each dollar of annual earnings. Note that last year’s P/E would be actual,
while current year and forward year P/E would be estimates, but in each case, the “P” in the
equation is the current price. Companies that are not currently profitable (that is, ones which
have negative earnings) don’t have a P/E ratio at all. For those companies you may want to
calculate the price-to-sales ratio (PSR) instead.
PEG
So is a stock with a high P/E ratio always overvalued? Not necessarily. The stock could have a
high P/E ratio because investors are convinced that it will have strong earnings growth in the
future and so they bid up the stock’s price now. Fortunately, there is another ratio that you can
use that takes into consideration a stock’s projected earnings growth: it’s called the PEG. PEG is
calculated by taking a stock’s P/E ratio and dividing by its expected percentage earnings growth
for the next year. So, a stock with a P/E ratio of 40 that is expected to grow its earnings by 20%
the next year would have a PEG of 2. In general, the lower the PEG, the better the value, because
you would be paying less for each unit of earnings growth.
Dividend Yield
The dividend yield measures what percentage return a company pays out to its shareholders in
the form of dividends . It is calculated by taking the amount of dividends paid per share over the
course of a year and dividing by the stock’s price. For example, if a stock pays out $2 in
dividends over the course of a year and trades at $40, then it has a dividend yield of 5%. Mature,
well-established companies tend to have higher dividend yields, while young, growth-oriented
companies tend to have lower ones, and most small growing companies don’t have a dividend
yield at all because they don’t pay out dividends.
Dividend Payout Ratio
The dividend payout ratio shows what percentage of a company’s earnings it is paying out to
investors in the form of dividends. It is calculated by taking the company’s annual dividends per
share and dividing by its annual earnings per share (EPS). So, if a company pays out $1 per share
annually in dividends and it has an EPS of $2 for the year, then that company has a dividend
payout ratio of 50%; in other words, the company paid out 50% of its earnings in dividends.
Companies that distribute dividends typically use about 25% to 50% of their earnings for
dividend payments. The higher the payout ratio, the less confidence the company has that it
would’ve been able to find better uses for the money it earned. This is not necessarily either good
or bad; companies that are still growing will tend to have lower dividend payout ratios than very
large companies, because they are more likely to have other productive uses for the earnings.
Book Value
The book value of a company is the company’s net worth, as measured by its total assets minus
its total liabilities. This is how much the company would have left over in assets if it went out of
business immediately. Since companies are usually expected to grow and generate more profits
in the future, most companies end up being worth far more in the marketplace than their book
value would suggest. For this reason, book value is of more interest to value investors than
growth investors. In order to compare book values across companies, you should use book value
per share, which is simply the company’s last quarterly book value divided by the number of
shares of stock it has outstanding.
Price / Book
A company’s price-to-book ratio (P/B ratio) is determined by taking the company’s per share
stock price and dividing by the company’s book value per share. For instance, if a company
currently trades at $100 and has a book value per share of $5, then that company has a P/B ratio
of 20. The higher the ratio, the higher the premium the market is willing to pay for the company
above its hard assets. Price-to-book ratio is of more interest to value investors than growth
investors.
Price / Sales Ratio
As with earnings and book value, you can find out how much the market is valuing a company
by comparing the company’s price to its annual sales. This measure is known as the price-tosales ratio (P/S or PSR). You can calculate the P/S by taking the stock’s current price and
dividing by the company’s total sales per share for the past year (or equivalently, by dividing the
entire company’s market cap by its total sales). That means that a company whose stock trades at
$1 per share and which had $2 per share in sales last year will have a P/S of 0.5. Low P/S ratios
(below one) are usually thought to be the better investment since their sales are priced cheaply.
However, P/S, like P/E ratios and P/B ratios, are numbers that are subject to much interpretation
and debate. Sales obviously don’t reveal the whole picture: a company could be selling dollar
bills for 90 cents each, and have huge sales but be terribly unprofitable. Because of the
limitations, P/S ratios are usually used only for unprofitable companies, since such companies
don’t have a P/E ratio .
Return on Equity
Return on equity (ROE) shows you how much profit a company generates in comparison to its
book value . The ratio is calculated by taking a company’s after-tax income (after preferred stock
dividends but before common stock dividends) and dividing by its book value (which is equal to
its assets minus its liabilities). It is used as a general indication of the company’s efficiency; in
other words, how much profit it is able to generate given the resources provided by its
stockholders. Investors usually look for companies with ROEs that are high and growing.
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