Company Fundamentals
Company fundamentals, like how much money companies earn and how efficiently they utilise their resources, drive the stock and CFD markets. Traders buy companies they believe will keep growing and sell companies they believe will stop growing. Learning a few basic fundamental concepts, as well as how to evaluate the data that professional traders act on, will help you to accurately anticipate market trends.
Company fundamentals wax and wane as the moon does, and consequently shares and CFDs ebb and flow like the tide. As a company fundamentally strengthens, the tide comes in, in effect. The company's ships come home on it, and this lifts the value of that company's share price. Yet, whenever company fundamentals weaken, it is like the tide going out. And, with that, there's a lowering of the company's share value.
Traders focus much of their attention on a handful of fundamental indicators when they evaluate a company. All such information, and more, is available to you too. So you have access to the self-same information that professionals use when they make buying and selling decisions. Thus by learning about company fundamentals, you can anticipate the direction a company's share price should move and then seize trading opportunities.
We will now address the following categories of fundamental information.
Stock and CFD traders initiate their fundamental evaluations by examining how much profit the company is making for its owners. Anyone who buys a stock share becomes an owner, so naturally they will be concerned about how much money the company is earning.
The fundamental data that alerts traders to how much money the company earned for each owner is called earnings-per-share, or EPS. To calculate EPS, traders take the company's overall earnings and divide them by the number of shares the company has issued. If a company earns $1billion and has 1 billion shares issued, the company's EPS is $1.
Once traders identify a company's EPS, they then examine share costs in relation to the earnings per share. The fundamental ratio that divulges this information is the price-to-earnings ratio, or P/E ratio.
The P/E ratio gives traders an inkling of whether a stock share is relatively overpriced or underpriced, which is crucial because traders looking to buy are looking for bargains. For example, if a share has an EPS of $1 and the share is trading for $20 then it has a P/E ratio of 20. By looking at historic P/E ratios, traders can assess whether the current P/E ratio of 20 is comparatively high or low.
Traders also want to know if companies are likely to increase earnings in the future. Good earnings today are helpful, but traders want to know if a company has a rosy future.
Luckily, you will not have to do the spade-work to work out if a company has good prospects. Large financial institutions employ armies of analysts to execute that kind of research, not only on the companies themselves but also on the industries in which they operate and how they should fare in future market conditions. Much of that information is available to the investing public.
When you are looking to buy, ensure the underlying businesses have real growth potential. When you are looking to sell, ensure the underlying businesses are likely to have little or no growth.
Once traders have evaluated the profit a company earns its owners, they tend to examine how efficiently the company utilizes its resources. Shares in efficient companies usually outperform shares in inefficient companies, since efficiency generally leads to greater profit and more earnings flow into owners' pockets.
One resource that traders prefer to see used efficiently is shareholder equity. Shareholder equity is company cash, hard assets and retained earnings (i.e. those which the company keeps to invest instead of distributing them to shareholders). Traders are interested in equity because if a company can't efficiently use such assets, they would be better invested elsewhere.
To monitor the efficiency of asset utilization, shareholders make a comparison similar to that which they make with price compared to the earnings in the P/E ratio. But this comparison is called the price-to-book ratio.
Suppose you have two piggy banks and both are notionally worth $100. However, the piggy banks are not identical. In the first you would find $100. Meanwhile in the second you would find only $10. Which piggy bank would you rather buy? Obviously you would want the piggy bank with $100 in it. A company price-to-book ratio is very similar.
To find a company's price-to-book ratio, you need the book value of the company, which equates to the shareholders' equity divided by the number of shares the company has issued. If a company has $5 billion in assets and issued a total of 1 billion shares, the company book value is $5 per share. That is how much money is inside the piggy bank per share. Next divide the current share price by the book value to get the price-to-book ratio. If the share trades at $20 its price-to-book ratio is therefore 4.
Like the P/E ratio, price-to-book ratios intimate whether current share prices are cheap or not.
Cash is a company's life-blood. Regardless of how a company performs, if it runs out of money, it will fold up. A company must pay its employees, vendors and shareholders. Shareholders want a dividend unless the company retains cash to grow itself and increase share value.
Some believe a company's bottom line, its net income, represents the cash the company generated. But that is not the case. Net income is what is left over after expenses are subtracted from revenues.
Net income is the government valuation when deciding tax liabilities. But governments need entrepreneurial growth to boost the economy and provide jobs, so incentives like depreciation and interest deductibility are allowed and can distort net income figures.
Traders are more interested in cash creation than earnings after adjustments, so they look at a company's free-cash-flow, its 'true' cash flow, and what it has had available to invest in new initiatives or to pay investors via dividends. A company's free-cash-flow is its net income plus both depreciation and amortization expenses, but then minus the company's changes in working capital and capital expenditures. See below.
Net income
+ Amortization
+ Depreciation
? Changes in working capital
? Capital expenditures
= Free cash flow
Traders also use a company's free-cash-flow data in a discounted-cash-flow analysis to see if its share price is expensive compared to the cash the company is able to generate.
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