There is a myriad of ways that an investor can approach stock picking. Some people prefer to find hidden gems by going through a company’s balance sheets, others prefer to rely on price chart analysis. Yet another class of traders may be value-based investors. In this article, we will be focusing on a fundamental based stock selection methodology.
Regardless of your personal preference, there are three important Fundamental Indicators which are essential to successful stock analysis and investing. They include
- Price to Earnings Ratio (P/E Ratio)
- Price to Earnings to Growth Ratio (PEG)
- Price to Book Ratio (P/B ratio).
What is Fundamental Analysis
Before we discuss the three major fundamental indicators that every stock investor should be familiar with, it is essential to understand what the core principle of fundamental analysis is.
Fundamental analysis, as it pertains to the valuation of stocks, is an analytical method that incorporates publicity available data on a company’s revenue, growth prospects, earnings, net profit margins, and other relevant data to assess the viability of purchasing or selling short shares in a specific company. Fundamental analysts typically believe that these data points are the most important in the determination of the intrinsic value of a company.
Contrary to fundamental analysis is technical analysis, wherein the analyst focuses on historical price data, volume and other technical indicators to determine the intrinsic value of a stock. Technical analysts believe that all publicly available information is already priced into the stock, and as such, the price charts provide the best clues for the future direction of that financial instrument.
Though there are some traders and investors that combine both fundamental and technical approaches into their investing decision processes, these two schools of thought tend to compete with each other and most market participants typically gravitate toward one or the other.
Price-to-Earnings Ratio (P/E Ratio)
The price to earnings ratio (P/E ratio) is the first important indicator that we will discuss. The P/E ratio is a simple but powerful metric for assessing the relative value of a stock by comparing its stock price with its current earnings. Essentially, the P/E ratio calculates the price the stock investor is paying per $1 of the company’s earnings.
P/E Ratio = Share Price / Earnings per Share
For example, if a company is reporting an earnings per share of $ 2.50 and the currently traded stock price is $50 per share, the P/E ratio would be calculated as $ 50 / $2.50 = 20. So, in this example, the Price to Earnings ratio would be 20. The beauty of the P/E ratio, if you implement it properly, is that it helps keep you grounded and less prone to being swept away by manias or hysteria in the market.
There are a few keys ways to use the P/E ratio in your analysis. But the way that I find it most useful is by utilizing it for comparing companies that are in the same sector or industry. So, for example, if you want to add a stock in your portfolio that is within the Consumer staples sector, the you could compare P/E ratios of those companies within that sector to find a potential stock that best meets your valuation criteria. It is important obviously to consider other factors as well, but all things being equal, the stocks with the lower P/E would be a more attractive buying opportunity.
Although the P/E ratio is typically the most widely used indicator when trying to assess the value of a stock, it does have its limitations. One obvious limitation is that is fails to take into account the company’s future expected growth.
The PEG Ratio helps solve this shortcoming of the PE ratio since it directly takes into account the future projected growth rate of a company.
Below you will find the calculation for PEG Ratio:
PEG ratio = P/E ratio / Earnings Growth rate
Let’s take an example to better illustrate how the PEG ratio works.
Assume you have narrowed down your selection process to two technology stocks. You have determined that Stock A has a PE ratio of 30 and Stock B has a PE ratio of 40. You want to consider the future growth prospects of each company before making a final decision. So, you take this one step further and compare each stocks PEG ratio now.
Assume that Stock A has an expected 3 year growth rate of 15% while Stock B has an expected 3 year growth rate of 25%.
Which is a better buy from the PEG standpoint?
Well, let’s plug in the numbers:
- Stock A PEG = 30 / 15 = 2
- Stock B PEG = 40 / 25 = 1.6
So even though Stock A has a lower P/E ratio, Stock B which has a lower PEG ratio, is a better value based on expected future growth.
Now the PEG ratio is not foolproof either. One of the most obvious problems that can arise from using it is that it is based on assumptions about the future growth of the company, which may or may not materialize.
Price-to-Book Ratio (P/B Ratio)
The last metric that we will discuss is called the Price to Book Ratio. Essentially the Price to Book Ratio measures the value per share over or below the company’s current asset value. The P/BV ratio is computed by dividing the price of a stock by its book value on a per share basis.
P/B Ratio = Price / Book Value
Let’s take a look at an example:
Assume that a company has $50 million in assets and has $10 million shares outstanding. This would mean that the book value is $ 5 per share. If each share of stock in that company is currently traded at $10, then the Price to Book Ratio (P/BV) would equal 2.
Investors should use the P/BV as a guide only, and look at the figures on a relative basis. For example, You could compare a company’s current P/BV to its P/BV 1 year ago, 3 years ago, or some other duration. In additional, you may consider comparing the P/BV of stocks within similar sectors as a valuation method. But keep in mind that P/BV used in isolation may not be that telling. It should always be used in a relative sense.
Now, that we have taken a look at all three of these important fundamental metrics, I encourage you to apply these indicators in your stock selection process. By doing so, you will find a good balance between value and growth in your stock portfolio.
This article is contributed by Vic Patel. He is a full time trader, mentor, and financial market expect. He also runs a popular trading blog at Forex Training Group.
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