Fundamental analysis has been a buzz in the investment world. But how do use it? Are you confused about intrinsic values and other stuff? Here’s the deal, I will share what I use in this post.
You can use pe ratio, price to book, current ratio and price to sales to do your fundamental analysis. Also, you can add the five-year earnings per share growth rate.
I use all of it to conduct my analysis of the stock. Also, I filter stocks under the criteria above to find good securities to buy.
This post is not for academic students, but it is for actual investors or traders.
Most of the time, these stocks are cheap and have the potential to grow in value.
First, if you want to invest in a stock, do not buy those that are expensive. One rule of thumb is to have a reason why the security is good.
Second, determine the criteria which we will be using in our fundamental analysis.
Finally, decide if you want to invest in the stock based on the criteria above.
What is the fundamental analysis?
When you do a search on the internet about fundament analysis, you’ll see a lot of useless guides. Sometimes, it is just a definition of it.
It’s like a mystery that only the analyst can do. Reading the post above made me think, I have to do something about it.
I’m not saying that they are wrong, but what I am going to teach here is something that is really useful to you.
Having read the results in my Google search you come empty-handed because you really do not know what to do.
All investment books always say you’ve got to buy a stock below its real value. However, how do you do that?
You know that value is subjective, yet lucky for us, wall street has created a measuring tool which we will discuss below. It’s a proxy for value to quantify the unknown.
In this post, I will share what I use in my actual stock trading. Also, these are not some academic lessons which you can learn in Finance Schools.
Just like Warren Buffet, Benjamin Graham is my idol. However, I have modified his criteria to fit my trading style as a quant. I don’t take a trade if I haven’t backtested the strategy.
Okay, enough of this, let’s go back to our topic.
Why you can’t rely on the fundamental analysis alone?
In fundamental analysis, the analyst has to study anything that affects the securities’ value. (source)
Although it is theoretically correct, most of the time, these things do not really affect the companies market price.
How many times have you seen a stock lost 50% of its value even though the company has an excellent earnings report?
It happened when a stockbroker sold the Cebu Pacific stock(CEB) for more than 50% below the price of the security’s value due to a fat finger error.
The stock plummeted even though there was no change in the company’s fundamentals.
As can be seen, we only use fundamental analysis to buy a potentially cheap stock.
We consider it only as potential because it is just an arbitrary value. We can’t perfectly value a brand like Coca-cola.
However, we know that the company is valuable.
Sooner or later you will realize that you need to combine fundamental analysis with technical.
However, in this post, I’m going to share to you what I do use in my analysis. Let’s now dive in!
You can combine some or all of these valuation metrics.
P/E ratio is a measure of price relative to its earning per share. Some investors and analyst use it to compare different stocks in the same sector. Measurement of PE ratio is relative to the industry the stock is in.
Losing companies do not have a PE ratio, and you should avoid that kind of stocks.
Wallstreet has made the traders believe that a PE ratio of 25 is not high enough if the average in the industry is near it.
However, veteran traders know that a PE ratio above 10 is high already.
I don’t buy a stock if it above that. Why do I do that?
Well, having a margin of safety has helped me avoid expensive stocks.
You’ll understand that 10 is a sweet spot. first, a premium is already incorporated into the price, yet it is not too high or low.
Also, Benjamin Graham used 9 or lower to have a margin of safety.
However, he did not say that it must be lower than 0, because undervalued stocks can remain low for years.
Okay, let’s go over to price to book.
Price to Book
Price to book ratio is the relationship between the market price and the book value per share of the company. To calculate, just divide the market price by the book value of the stock.
Buying stocks below the book value makes sense. However, most of these companies are trading below it because they are not performing well.
An undervalued stock can stay undervalued for a long time. Why do you think the market has priced it below the company’s net worth?
You would not want to invest in a company that may not increase in price. Also, a bargain is not always a good thing.
Just like the PE ratio, we must add a premium to the price. Under 5 is okay. As long as it did not go below the book value, we are good to go.
The premium in the price indicates a healthy outlook of the stock.
I hope you understand what I mean, and this must be new to you.
You may have heard famous investors say to buy a stock at 50% a dollar. However, do not take it literally because they are referring to intrinsic value.
I look at the current ratio when considering a stock to buy. You should determine if the company can pay its current obligations.
As a matter of fact, if the current ratio is less than one, it means the company can not pay their short-term debts. Also, it is possible that they may be near insolvency.
The formula is current assets divided by current liabilities. Current assets are the resources of the company which can be easily converted into cash within one year.
While current liabilities are payables to creditors that are due within one year.
You can assess whether the company has solid viability. Always ask yourself, can they pay their current outstanding debts?
As a caveat, the current ratio does not reveal the overall picture of the company’s short-term liquidity.
For example, even though the current ratio is above one, the receivables may be aged for a long time.
It means that receivables are uncollected beyond 12 months. The customers may have been paying slowly their obligations to the company.
Yes, some company fakes its financial statements to look better.
You should not forget to look at the age of the company’s receivables to verify current ratio.
Some analysts consider high current ratio as a bad thing because the management may have left cash unutilized.
However, you probably already know that cash is king.
Price to sales ratio
Another fundamental analysis we do use is the price to sales ratio. If you’ve been investing for quite some time, you may have learned that buying stocks 10 times price to sales is a bad idea.
I’ve written this article here on our website. Well, the title is “Receiving a buy signal”. Look it up at, and I’m sure you will learn something important in trading.
Something like this, “johndeo research receiving a buy signal”.
You can calculate prices to sales ratio by dividing the stock price by sales per share.
The lower the value the more attractive the security is.
Price to sale ratio can be an alternative to valuing stocks if the PE ratio is zero because the company might be having negative earnings.
However, a high ratio does not mean the company is struggling. For example, construction companies have a high ratio, yet they have large profits.
Just like any other ratios, you have to correlate it to other indicators. Also, A low P/S company with small debts is an attractive investment.
However, only using this ratio does not reveal the real value of the company, but it is a good metric to use.
Together with the four ratios, we have discussed above, you already have an acceptable fundamental analysis.
But I still want to suggest the final metrics we can use.
Earnings per Share Growth Rate
Fundamental analysis is not complete if you don’t include earnings per share growth rate. It is just a way to check if the company have grown consistently.
You just have to average the growth of the earnings per share for the last five years.
You would not want to invest in a company with no improvement in earnings.
Have you heard about C-A-N-L-I-S-M strategy? It stands for:
- Current quarterly earnings
- Annual earnings growth
- New product or service
- Supply and demand
- Leader or laggard
- Institutional sponsorship
- Market Direction
The strategy requires that the Annual Earnings growth should have at least a minimum of 25% for the last three years.
If you strictly follow the rules, it is kind of difficult to find stocks that meet the criteria.
However, I don’t really trade C-A-N-L-I-S-M because I’m a pure quant. I can’t backtest whether a company has new products or services.
What is the optimal percentage? You might be asked me.
I suggest you use at least 10% as optimal. Well, If you can’t find stocks, you can lower it.
What is important is the company you invest in keeps growing. However, if you set the criteria too high, you leave out a lot of good stocks in the table.
Finally, we will talk about momentum. Although this is not part of fundamental analysis, it essential.
One of the mistakes you can make is investing in a company that has price consolidation.
It means the price has not moved for years. It’s frustrating to invest in those kinds of companies because it has not earned you a dime.
Momentum has to be combined with fundamental analysis.
Unless you can live up to 90 years, time is important. You can’t wait 20 to 30 years before you’ll see results.
Only invest in stocks with high momentum. It will give you the best bang for your bucks at the shortest possible time.
I’ve written this over and over again in my articles. If you want to know more, just search our site.
Given these points, you now have a robust fundamental analysis. You can always add more. But if you are a small investor this is already complete.
What fundamental analysis do you use? You can share it in the comment section below.