Fundamental Analysis Part Two – Tools

 

  

Although the raw data of the Financial Statement has some useful information, much more can be understood about the value of a stock by applying a variety of tools to the financial data.

 

Earnings per Share

The overall earnings of a company is not in itself a useful indicator of a stock’s worth. Low earnings coupled with low outstanding shares can be more valuable than high earnings with a high number of outstanding shares. Earnings per share is much more useful information than earnings by itself. Earnings per share (EPS) is calculated by dividing the net earnings by the number of outstanding shares. For example: ABC company had net earnings of $1 million and 100,000 outstanding shares for an EPS of 10 (1,000,000 / 100,000 = 10). This information is useful for comparing two companies in a certain industry but should not be the deciding factor when choosing stocks. A high EPS is typically seen as a positive indicator of a company’s profitability and financial health.

$\text{EPS} = \frac{\text{Net Income} – \text{Preferred Dividends}}{\text{Weighted Average Shares Outstanding}}$

​

 

Price to Earning Ratio

The Price to Earning Ratio (P/E) shows the relationship between stock price and company earnings. It is calculated by dividing the share price by the Earnings per Share. In our example above of ABC company the EPS is 10 so if it has a price per share of $50 the P/E is 5 (50 / 10 = 5). The P/E tells you how much investors are willing to pay for that particular company’s earnings. P/E’s can be read in a variety of ways. A high P/E could mean that the company is overpriced or it could mean that investors expect the company to continue to grow and generate profits. A low P/E could mean that investors are wary of the company or it could indicate a company that most investors have overlooked.

 Either way, further analysis is needed to determine the true value of a particular stock.

$\text{P/E Ratio} = \frac{\text{Current Share Price}}{\text{Earnings Per Share (EPS)}}$

 

 

Price to Sales Ratio

When a company has no earnings, there are other tools available to help investors judge its worth. New companies in particular often have no earnings, but that does not mean they are bad investments. The Price to Sales ratio (P/S) is a useful tool for judging new companies. It is calculated by dividing the market cap (stock price times number of outstanding shares) by total revenues. An alternate method is to divide current share price by sales per share. P/S indicates the value the market places on sales. The lower the P/S the better the value.

$\text{P/S Ratio} = \frac{\text{Market Capitalization}}{\text{Total Revenue}}$

​

 

Price to Book Ratio

Book value is determined by subtracting liabilities from assets. The value of a growing company will always be more than book value because of the potential for future revenue. The price to book ratio (P/B) is the value the market places on the book value of the company. It is calculated by dividing the current price per share by the book value per share (book value / number of outstanding shares). Companies with a low P/B are good value and are often sought after by long term investors who see the potential of such companies. A P/B ratio significantly below 1.0 indicates that a stock is trading for less than its book value, potentially suggesting undervaluation. Conversely, a ratio above 1.0 reflects a premium valuation relative to the company’s book value.

$\text{P/B Ratio} = \frac{\text{Current Share Price}}{\text{Book Value Per Share}}$

​

 

Dividend Yield

Some investors are looking for stocks that can maximize dividend income. Dividend yield is useful for determining the percentage return a company pays in the form of dividends. It is calculated by dividing the annual dividend per share by the stock’s price per share. Usually it is the older, well-established companies that pay a higher percentage, and these companies also usually have a more consistent dividend history than younger companies.​ A high dividend yield, often considered above 4-5%, suggests a company provides substantial returns to its shareholders through dividends relative to its stock price. 

$\text{Dividend Yield} = \frac{\text{Annual Dividends Per Share}}{\text{Current Share Price}} \times 100$

 

Return on Equity

Return on Equity (ROE) is a critical financial metric used to evaluate a company’s profitability in relation to its shareholders’ equity. It measures how effectively a company is using its equity base to generate profits. ROE is expressed as a percentage and is calculated using the formula:

$\text{ROE} = \frac{\text{Net Income}}{\text{Shareholders’ Equity}} \times 100$

Generally, an ROE above 15% is considered strong. ROEs in the 20% to 30% range are often viewed as excellent, reflecting high profitability and efficient use of equity.

Current Ratio

The Current Ratio is used to assess a company’s ability to meet its short-term obligations with its short-term assets. It provides insight into a company’s liquidity and financial health, particularly in terms of its capacity to pay off its current liabilities using its current assets.

A Current Ratio above 2.0 is generally considered high, indicating that the company has more than twice as many current assets as current liabilities, which suggests strong liquidity and a solid ability to meet short-term obligations. A ratio around 1.0 shows that the company’s current assets are just sufficient to cover its current liabilities, indicating a balanced position but with limited cushion for unexpected issues. A Current Ratio below 1.0, on the other hand, implies potential liquidity problems, suggesting the company may struggle to meet its short-term debts with its available current assets.

$\text{Current Ratio} = \frac{\text{Current Assets}}{\text{Current Liabilities}}$

​

Working Capital

Working Capital is a vital indicator of a company’s operational efficiency and short-term financial health. It helps assess the company’s ability to manage its day-to-day operations, cover short-term liabilities, and invest in growth. While positive working capital generally suggests good financial stability, negative or low working capital may indicate potential liquidity challenges.

Working Capital=Current Assets−Current Liabilities

If a company has current assets of $800,000 and current liabilities of $500,000, the Working Capital would be:

Working Capital=800,000−500,000=300,000

This means the company has $300,000 in working capital available to support its operations and growth.

 

 

Debt-to-Equity Ratio

The Debt-to-Equity Ratio is a key measure of financial leverage, providing insight into a company’s use of debt relative to equity. It helps assess the company’s financial risk and capital structure. A ratio below 1.0 suggests the company uses less debt relative to equity, indicating lower financial risk and a conservative approach. A ratio between 1.0 and 2.0 reflects a balanced use of debt and equity, showing moderate leverage and financial stability. A ratio above 2.0 means the company relies heavily on debt, which can increase financial risk but might also enhance potential returns.

$\text{Debt-to-Equity Ratio} = \frac{\text{Total Debt}}{\text{Shareholders’ Equity}}$

 

 

Net Tangible Assets

Net Tangible Assets (NTA) refers to the value of a company’s tangible assets minus its liabilities and intangible assets. It provides insight into the company’s net worth based on physical assets that can be used to cover obligations, excluding intangible assets like patents or goodwill. If NTA is below the market price, it often means the company is valued for its intangible assets or growth potential rather than just its tangible assets. This does not necessarily indicate undervaluation but reflects market expectations and premium pricing.

Net Tangible Assets=Total Tangible Assets−Total Liabilities

 

These indicators collectively provide a comprehensive view of a company’s financial health, profitability, valuation, and liquidity. Investors use them to assess whether a stock is attractively priced and how it compares to industry standards and peers.