A Profitable Company Will Always Have Positive Cash Flows Stock Market – How to Use Fundamental Analysis to Make Trading Decisions

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Stock Market – How to Use Fundamental Analysis to Make Trading Decisions

Stock analysis

Investors come in many shapes and forms, so to speak, but there are two basic types. The first and most common is the more conservative type, which picks stocks by looking at the company’s fundamental value and doing research. This belief is based on the assumption that as long as a company is well run and continues to make a profit, the share price will rise. These investors seek to buy growth stocks, which are likely to continue to rise over the long term.

Another but less common type of investor tries to predict how the market may behave based on the psychology of market people and other similar market factors. The second type of investor is commonly called a “quant”. This investor assumes that the price of the stock will rise as the stock price continues to be bid back and forth as in an auction (often without considering the stock price). They often take on very high risks with high potential returns—but with a high probability of high losses if they fail.


To find the intrinsic value of a stock, investors must consider several factors. When a stock’s price is in line with its value, it has reached an “efficient” market target. Efficient market theory states that a stock is always priced correctly because everything that is publicly known about the stock is reflected in its market price. This theory also suggests that analyzing a stock is meaningless because all known information is reflected in the current price. Simply put:

  • The stock market determines the price.
  • Analysts weigh known information about a company and thereby determine value.
  • Price need not equal value. Efficient market theory is a theory as the name suggests. If that is the law, then prices adjust to information immediately as it becomes available. Since this is theory rather than law, it is not. Stock prices move above and below company values ​​for both rational and irrational reasons.

Fundamental analysis attempts to determine the future value of a stock by analyzing the current and/or past financial strength of a particular company. Analysts try to determine whether a stock’s price is overvalued or undervalued and what that means for the stock’s future. Several factors are used for this purpose. Basic terminology that helps investors understand analysts’ determinations includes:

  • “Value stocks” are those that are below market value and include bargain stocks listed at 50 cents per dollar of value.
  • “Growth stocks” are those with earnings growth in primary consideration.
  • “Income Stocks” means investments that provide a steady source of income. This is primarily through dividends, but bonds are also common investment instruments used to generate income.
  • “Momentum stocks” are growth companies currently entering the market picture. Their share prices are rising rapidly.

In order to make the right basic decision, all the following factors must be considered. The underlying terminology will be the determining factor in how each will be used, based on the investor’s bias.

1. As always, the revenue of a particular company is the main determining factor. A company’s earnings are profits after taxes and expenses. Stock and bond markets are primarily driven by two powerful dynamics: earnings and interest rates. Money flows in these markets are often fiercely competitive, moving into bonds when interest rates rise and into stocks when earnings rise. More than any other factor, a company’s earnings create value, although other considerations must be made with this notion.

2. EPS (earnings per share) is defined as the amount of reported earnings per share, which a company has at any given time to pay dividends to common shareholders or to reinvest in itself. This indicator of a company’s condition is a very powerful way to predict stock prices. Earnings per share is one of the most widely used fundamental ratios.

3. A stock’s fair value is also determined by the P/E (price/earnings) ratio. For example, if a certain company’s stock is trading at $60 and its EPS is $6 per share, its P/E is 10, which means investors can expect a 10% cash flow return.

Equation: $6/$60 = 1/10 = 1/(PE) = 0.10 = 10%

Along the same lines, if it makes $3 per share, its multiples are 20. In this case, as long as the current conditions remain the same in the future, the investor can get a return of 5%.

Example: $3/$60 = 1/20 = 1/(P/E) = 0.05 = 5%

Some industries have different P/E ratios. For example, banks have low P/Es, usually in the range of 5 to 12. High tech companies tend to have higher P/E ratios, typically 15 to 30. On the other hand, not far behind, triple-digit P/E ratios have been seen for Internet-stocks. These were stocks with no earnings but high P/E ratios, defying theories of market efficiency.

A low P/E is not a true indication of accurate value. Price volatility, range, direction, and noticeable news regarding the stock should be considered first. An investor should also consider why any given P/E is low. P/E is best used to compare industry-similar companies.

The Beardstown Women Any P/E ratios below 5 and/or above 35 should be closely scrutinized for errors, as the market average has historically been between 5 and 20.

Peter Lynch It suggests comparing the P/E ratio with the company’s growth rate. Lynch considers a stock to be fair value only if the stock is at par. If it is lower than the growth rate, it may be a stock bargain. To put this into perspective, the basic understanding is that a P/E ratio that is half the growth rate is too positive and one that is twice the growth rate is too negative.

Other studies have indicated that a stock’s P/E ratio has little influence on the decision to buy or sell a stock (William J. O’Neill, founder of Investor’s Business Daily, in his study of successful stock moves). He says the stock’s current earnings record and year-over-year earnings growth are key.

It must be mentioned that the value represented by P/E and/or earnings per share is useless for investors before buying a stock. Money is made after the stock is bought, not before. Hence, both dividends and growth will pay in the future. This means that investors need to pay as much attention to forecasts of future earnings as to historical records.

4. The basic PSR (price/sales ratio) is similar to the P/E ratio, except that the share price is divided by sales per share as opposed to earnings per share.

  • For many analysts, PSR is a better value indicator than P/E. This is because earnings often fluctuate, while sales follow a more reliable trend.
  • PSR may also be a more accurate measure of value because sales are more difficult to manipulate than earnings. The credibility of financial institutions has been shaken by the Enron/Global Crossing/WorldCom, et al, debacle, and investors have learned how large financial institutions are manipulated.
  • PSR itself is not very effective. It is only used effectively with other remedies. James O’Shaughnessy observed in his book What Works on Wall Street that PSR becomes the “king of value factors” when used as a measure of relative strength.

5. Debt ratio shows the percentage of a company’s debt compared to shareholder equity. In other words, the extent to which the company’s operations are being financed through debt.

  • Remember, less than 30% is positive, more than 50% is negative.
  • A successful operation with rising profits and a well-marketed product can be destroyed by a company’s debt load, as revenue is sacrificed to pay off debt.

6. ROE (return on equity) is found by dividing net income (after taxes) by owner’s equity.

  • ROE is often considered the most important financial ratio (for stockholders) and the best measure of a company’s management ability. ROE gives stockholders the confidence they need to know their money is well managed.
  • ROE should always increase on an annual basis.

7. The price/book value ratio (aka market/book ratio) compares the market price of a stock to its book value per share. This ratio relates the value of a company (stock) according to investors to the value according to the company’s accountants according to accepted accounting principles. For example, a low ratio would indicate that investors believe that the company’s assets are overvalued based on its financial statements.

Investors expect shares to trade at book value, but in reality, most stocks either trade at a premium or at a discount to book value.

Stocks trading at 1.5 to 2 times book value are on the horizon when looking for value stocks. Growth stocks support higher ratios, as they offer higher earnings expectations. A stock with a wholesale price below book value would be ideal, but this is rarely the case. Companies with low book values ​​are often the targets of takeovers and are generally avoided by investors (at least until the takeover is completed and the process restarted).

Book value was more important when most industrial companies had real hard assets like factories to back up their stock. Unfortunately, the value of this measure has diminished as undercapitalized companies have become commercial giants (i.e. Microsoft). Videlicet, look at the low book value to keep the data in perspective.

8. Beta compares the stock’s volatility with that of the market. A beta of 1 suggests that the share price moves up and down at the same rate as the overall market. A beta of 2 means that the stock is likely to double that amount when the market falls. A beta of 0 means it doesn’t move at all. A negative beta means it moves in the opposite direction of the market, resulting in a loss for the investor.

9. Capitalization is the total value of all outstanding shares of a company and is calculated by multiplying the market price per share by the total number of outstanding shares.

10. Institutional ownership is the percentage of a company’s outstanding shares owned by institutions, mutual funds, insurance companies, etc., which move in and out of positions in very large blocks. Some institutional ownership can actually provide a measure of stability and contribute to the roll with their buying and selling respectively. Investors consider this an important factor because they can utilize the extensive research conducted by these institutions before making their own portfolio decisions. The importance of institutions in market action cannot be overstated and account for more than 70% of the dollar in daily transactions.

Market efficiency is always the goal of markets. Anyone who puts money into stocks likes to get a return on their investment. However, as mentioned earlier, human emotions will always drive the market, causing common stocks to go up and down in value. Investors need to use modern computing tools to take advantage of the patterns so that stocks are undervalued as well as develop appropriate responses to these market patterns, such as moving in channels with intelligence (identifying trends).

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