The How?
Stock market analysts often use both disciplines in their research on a weekly basis, and some of the terms can be convoluted, especially so for new investors. So we're taking a closer look at fundamental analysis, and the terms used in this investment discipline.
What is fundamental analysis?
This is a method used by analysts to determine the intrinsic value of a company, by examining the state of the economy and industry as a whole (macroeconomic), as well as a company’s financial statements and management’s efficacy (microeconomics). The main aim in understanding the intrinsic value is for an investor to compare it to the share's current price, and evaluate whether a stock is under or overvalued.
If the intrinsic value is higher than the current market price, the stock is deemed to be undervalued. That's when analysts recommend a stock to be bought (aka, 'buy recommendation'). If the intrinsic value is lower than its market price, the stock is considered overvalued and a sell recommendation is issued.
Still curious about the terms used by fundamental analysts? Below are some of the terms used within our research notes. Remember, these concepts have been expressed in layman’s terms:
EPS (Earnings per share)
This is every analyst's favorite. Earnings per share serves as an indicator of a company's profitability. This would be the portion of a company's after-tax profit (or loss), allocated to each outstanding share of common stock. EPS is calculated as EPS = (Net Income - Dividends on Preferred Stock) / Average Outstanding Shares.
Earnings Per Share is also a major component used to calculate the price-to-earnings (P/E) valuation ratio, where the 'E' in P/E refers to EPS. Which brings us to...
P/E ratio (Price-to-Earnings ratio)
There are many ways and techniques investors use to select stocks, but the Price to Earnings ratio (P/E) is probably one of the most popular stock selection tools used today.
Usually, a stock with a high P/E ratio can indicate higher growth prospects but is not necessarily a better investment than one with a lower P/E ratio. However, a stock with a high P/E ratio can indicate that the stock is being overvalued and may be sold off by investors.
Dividend yield
The dividend yield is also a ratio and is the ratio of a company’s annual dividend compared to its share price. It is expressed as a percentage, where we divide dividends paid in one year per share by the value of a share.
Outstanding shares (or shares outstanding)
Shares outstanding refer to a company's stock currently held by all its shareholders, including share blocks held by institutional investors and restricted shares owned by the company’s officers and insiders.
Market capitalization
Market capitalization refers to the total market value of a company's outstanding shares. Commonly known as "market cap". It is calculated by multiplying a company's shares outstanding by the current market price of one share. The fundamental analysts use this figure to determine a company's size, as opposed to using sales or total asset figures.
Return on equity (RoE)
Divide the company's net income by shareholders' equity to find its return on equity. You might also hear this expressed as the company's return on net worth.
EBITDA (Earnings Before Interest, Tax, Depreciation, and Amortization)
Analysts calculate this metric to measure the underlying operating performance of a company, excluding the effects of financing, asset investment, taxes, and abnormal items. So, EBITDA indicates a company’s financial performance and is a close approximation of earnings potential.
The only drawback is that EBITDA strips out the cost of debt capital and its tax effect by adding back interest and taxes to earnings.
DCF (Discounted cash flow)
Discounted cash flow is a proven valuation technique that takes estimated future cash flows and discounts these cash flows, using the cost of capital appropriate to the company in question. This brings us to the present value. The present value estimate is then used to evaluate the investment potential.
Professional designations associated with fundamental analysis
If you are new to investing and you have no idea how to read a financial statement and would rather want to follow the opinion of a fundamental analyst, make sure that they hold a professional designation. The most recognizable (for fundamental analysis) is the Chartered Financial Analyst (CFA) designation. And more recently, the Chartered Alternative Investment Analyst (CAIA).
Sources – Investopedia, CFA Institute, the balance