Fundamental Analysis Basics

Fundamental Stock Analysis

Fundamental analysis uses various metrics to assess the business’ health and future prospects.  The most common metrics include price-to-earnings ratio, dividend yield, return on equity, debt-equity ratio, gross margins, earnings per share growth, and net profit.  Fundamental analysts will often use these ratios to compare a company to others within its industry.  They perform these comparisons to draw conclusions about the efficiency and profitability of its business operations to ultimately determine whether they think a company’s stock is over or under valued.

Price-to-earnings ratio (P/E)

The P/E of a company is its stock price divided by current earnings per share (EPS).  It is also commonly referred to as the earnings multiple and may be seen as a measure of investor confidence.  P/E ratios are very much industry dependent.  For example, companies with mature low growth industries will tend to have significantly lower P/Es than fast growing technology companies.  You’ll need to find the right “comps” (comparable companies) to whether the stock is expensive or cheap relative to its peers based on the P/E.  Value oriented investors will generally invest in companies with lower P/Es where growth oriented investors will favor companies with higher P/Es.

Dividend Yield

The Dividend Yield is the per share annual dividends of a company divided by the current share price.  Younger fast growing companies tend not to pay dividends, rather reinvesting profits to further develop its business and thus tend to have dividend yields of 0%.  Mature established businesses with limited growth prospects will return capital to to investors via dividend payments.  Income investors will often look at the dividend yields of various companies to make investment decisions.

Return-on-Equity (ROE)

ROE is calculated by dividing a company’s annual earnings by average annual shareholder equity.  You may note that this is pretty much the mathematical inverse of the P/E Ratio.  Thus, higher P/E companies then to have lower ROEs and vice versa.

Via the Dupont decomposition, we know that a company’s ROE is impacted by its profit margin (profit/sales), use of leverage (assets/equity), and operational efficiency (sales/assets).  This type of analysis and comparison is very useful for fundamental analysts.  For example, although some companies may have similar ROEs, however, one might have lower margins than the others and uses leverage to boost the ROE to meet its peers.

As with previous metrics, ROEs can vary greatly across industries and so its important to identify comparable companies when drawing conclusions with respect to a company’s ROE.

Gross margin

A company’s gross margins is equal to the sales minus the cost of goods sold, divided by the sales. It shows the profitability of a company’s business before including other operational expenses. If gross margins are fairly thin, it means a company does not revenue to support operational expenses, debt service and taxes. Comparing gross margins across companies will allow help fundamental analysts determine which company is able to source cheaper goods overall.

EBITDA Margins

EBITDA stands for earnings before interest, tax, depreciation and amortization. A company’s EBITDA margins is equal to the sales minus the cost of goods sold and operating expenses, divided by the sales.

EBITDA and EBITDA Margins are an especially important metric to fundamental analysts and corporate finance professionals as it captures the company’s cash profit. It excludes non-cash expenses like depreciation and amortization and doesn’t take into account to the current capital structure (mix of debt and equity financing).

EBITDA and EBITDA margins are thus often used when comparing different companies in the same industries with different capital structures or tax obligations. It is also a useful tool for analysis when you think of increasing equity financing percentage (share issuance or debt repayment) or increasing debt financing mix (increasing loans or bonds or share buybacks).

Net profit margin

A company’s net profit margin is sales minus cost of goods sold, operational expenses, interest, depreciation and taxes, divided by sales. It is an assessment of the profitability of a company once all costs are subtracted.
The net profit margin compares a business’ net profits to its revenues. Calculate the ratio by dividing the company’s net profit by revenue. Net profit equals revenue less cost of goods sold less operating expenses, interest and taxes. This figure shows what portion of each dollar the business earns is used to generate profits.

EPS Growth

EPS Growth is the year over year change in a company’s earnings per share. This is an important measure of a company’s future business prospects. Company’s with higher EPS growth tend to have higher P/E multiples than their peers.

Price-Book (P/B) Ratio

The P/B is the stock price by net assets (minus intangibles on the books, such as good will). This metric can help investors know more about what they’re paying for a business’ assets.

Free Cash Flow

Free Cash Flow is Operating Cash Flow minus Capital Expenditures. Reviewing free cash flow is also wise because, corporate earnings seldom reveal the amount of cash profits the business brings in. Even if the business is reporting good earnings, cash on hand might be low if most profits are simply accounting gains (e.g. increases in accounts receivables) or if the company makes significant investments in plant, property and equipment. It will give you advance warning of any liquidity issues a company may face in the future.

Stock Trading Order Types

Stock Trading Order Types

There are many different types of stock trading order types including market, limit, stop loss, stop limit, and conditional orders.  Knowing when to use each can greatly aid your trading activity.  Choosing the right one can help you avoid or reduce losses, lock in profits and free you from having to spend the entire trading day in front of your screen.

Market Orders

Many traders will place orders with their brokers or financial advisors without conditions or restrictions when they buy or sell stocks.  Clients simply authorize their broker-dealer to buy or sell a given quantity at the current price. This authorization is called a market order. The order is unconditional and a broker-dealer executes the trade immediately at the current market price.

Conditional Market Orders

There are several types of the market orders.

All or None

A slight variation of the market order is the all or none order. Let’s say only a few thousand shares of ABC trade each day. If the investor wants to own 3,000 shares of ABC now, he or she can tell the broker to place the trade “All or None.” The investor must receive all the shares in a single trade and not receive partial fills of the order. That way, if there aren’t enough shares offered for sale—if the supply is too small—the trade is cancelled at market close.

Fill or Kill

In comparison, a fill or kill (FOK) order can be used when buying or selling stock. The investor placing the order instructs the broker-dealer to buy or sell all (fill) or not (kill, or cancel).

Good Til Cancelled

Placing a good til cancelled (GTC) order instructs the broker-dealer to work on the client’s transaction until it’s completed or canceled. Without the instruction of GTC, the client’s order expires at the close of trading session.

Day Order

It’s also possible to instruct the broker to complete the order during the trading session by placing a day order. If the trade isn’t completed in the day the client gives the day order, his or her trade is cancelled.

Time of Day

There are times when an instruction of buy/sell on the open or on the close can make a huge difference in trading results. For instance, the investor owns shares of an actively traded new issue, XYZ. The shares double in price on the first day and, to book the profit, the investor authorizes sell on the close of the trading session.

Limit Orders

In the market order, the trader only specifies the quantity and direction of a trade.  However, in a limit order, the trader specifies the quantity, direction and price.  A limit order instructs the broker-dealer to buy shares up to but not exceeding the “limit price” or sell shares up to but not below the “limit price.”

For illustration:

• In a buy limit order, the transaction is executed only when the stock price is equal to or less than the limit price. For example, an investor wants to buy 1,000 shares of ABC with a limit of 25. The limit buy order is filled at 24-7/8.

• In a sell limit order, the transaction is executed only at an equal or higher than limit price. For instance, an investor instructs the sale of 1,000 shares of ABC at 25. The limit sell order fills at 25-1/8.

This can have some risk reduction benefits especially when the market gaps rapidly.  If the price rapidly rises, a limit buy order prevents you at buying at a price that might be too high.  If the price rapidly declines, a sell limit order may prevent you from selling and closing out a position at a price that is too low.  Obviously, placing a limit order can mean that the trade isn’t executed at all. However, establishing limits can potentially reduce the volatility of your trading portfolio.

Day traders tend to place more limit orders than other investors as small price movements more greatly affected the profitability of their trades. However, all investors can benefit from the use of limit orders.  For example, if you are long term bullish on a stock but expect it to decline in the short term, you can put in a buy limit order below to current market price and wait for the order filled when it hits your limit price.  Further, if you waiting for a stock to reach your long term profit target, you can enter a good til cancelled sell order which will be triggered when the market price hits your limit price.

Stop Loss Orders

Entering a stop loss order may help a trader limit the downside risk of a trade.

Stop Market Order

For illustration, supposed a trader purchased 1,000 shares of ABC at $24 and it is currently trading at $26. The investor wants to protect his $2,000 unrealized gain but doesn’t want to sell shares yet.  The investor places a stop loss order for 1000 shares of ABC at $25. If ABC falls to $25, the investor’s shares are automatically sold.  Although the trade has moved against him, the trader will make still make $1,000 profit on this position (net of commissions).

Trailing Stops

Traders will often like to keep the “stop” price close to the market price of a stock.  Having “tight stops” allows them to limit the downside risk while still benefiting from increases in the stock price over time.  However, manually adjusting the “stops” can be rather labor intensive so many brokers offer something known as trailing stop orders.

A trailing stop order automatically adjusts the “stop” price to be either a certain dollar amount or percentage below closing price of the stock as of the previous trading day.  Putting in a trailing stop order allows traders to avoid having to manually adjust stop prices while still giving similar downside protection and upside potential.

Short Sales

Traders can benefit from declines in stock prices by “shorting” stocks.  Traders borrows stock from a broker-dealer and then sells the shares short (without actually owning them).  A short sale is in inverse of a long stock position. The investor makes money if the share price declines. The amount of money he or she makes is equal to the borrowed shares’ value at sale minus the cost needed to repurchase the shares:

Suppose a trader is bearish on ABC. They sell short 1,000 shares of ABC at $25.  If the share price declines to $23, makes a $2000 profit, less margin and transaction costs.  If the share price increases to $26 and they decide to close out the short position, they will purchase the shares at the prevailing market price of $26 and sustain a $1000 loss.

Shorting stocks is generally reserved for advanced traders given the additional logistical complexity.  There is also some element of additional risk to shorting stocks over only buying stocks.

For a long only trader (who doesn’t use margin), a stock price cannot go below zero so the most you can lose if your initial outlay.  For a trader who also shorts stocks, stock prices do not have upper bound limits which means there is the potential for infinite losses.

Summary

Orders are different types of tools in a trader’s tool kit.   A skilled trader will choose the one that best suits his purposes.

For easy reference, here is a short video with some recapping some of the different order types.

6 Stock Trading Tips for Beginners

Stressed Trader

Stock trading is not as easy as some say.  There are many people promising some unrealistic results with little effort. It’s easy to see why some people get caught up in the hype and end up making some very simple but costly mistakes.

I am here to help prevent this from happening to you.  My hope is that you take some of these simple suggestions and incorporate them in your stock trading activity.

Choose your Broker Wisely

It’s not a bad idea to use online discount brokers, but you need to be careful with whom you get involved with. Many of them will try to loop you in with low commissions but include a number of other service fees, inactivity fees, statement fees, etc..  Commissions are not the only factor you need to should watch out for.

Please also be sure to make sure they have good trade execution practices, offer timely and accurate price data, provide access to good equity research, and have a good, clean regulatory record.

Money Management

Only trade with money you can afford to lose.  Do not use money you need for basic living expenses. I have seen it happen. You would be amazed how many feel they have a “sure bet” and load up on a position. They end up losing and getting being behind in their bills.

Set aside disposable income for trading. Funds you are not afraid to use. I am not trying to scare you, but many of you will end up with losing trades in the beginning.  It’s important to manage the size of your positions such that the amount you risk is acceptable and losses do not cause your trading portfolio to implode.

Don’t Jump on the Hype Train

There are going to be stocks who rises quickly seemingly with no end in sight. There can get to a point where they are too expensive to buy.  You’ll need to perform detailed fundamental and technical research to assess if there is any more upside potential. Learn how to be skilled at knowing the difference between an over-hyped stock and something that is a good buy.

Limit Orders

Use limit orders instead of market orders. A limit order places a maximum price you are willing to pay per share.  If you place a market order, you could end up paying a lot more than you expect if the stock price suddenly gaps up.

Let’s say a stock is trading around $11.95.  You are comfortable buying it at up to $12.10 but think anything more would be too expensive. If you place a market order and the price suddenly increases to $12.25, you would end up overpaying for the shares.  If you placed a limit order of $12.10, your order would simply not be filled.

Trade Discipline

Those who fail to plan, plan to fail.  Make sure you plan your stop losses and take profit levels when initiating a trade.  Beginners tend to have a bad habit of letting losers run.  This can turn a small loss into a big one unless you sell your losers.  One good way of enforcing trade discipline is to set stop loss orders shortly after your position is established.

Conversely, some novice traders don’t plan exits for profitable trades with enough care.  If you hold onto a stock for too long, the price can also dip over time.  It’s advisable to have pre-determined take profit levels where you will sell at least a portion of your shares so you can lock in a profit.

Learn from Your Mistakes

Be patient. Everyone has some bad days in the market.  It’s important to have the patience to stick it out and wait for better days. Learn to take your mistakes and grow from them.  Hold yourself accountable for your trading decisions.  Make sure you keep a detailed trading journal so you can document your good and bad trades, analyze what you did well and where you could improve.  Journalling is a important tool to developing your skills as a trader.

5 Stocks to Watch for the 2nd half of 2016

Buy Sell

The first half of 2016 began with dire warnings followed by a decisive downward spiral to the overall stock positions in the United States of America and around the world. There are naysayers and pundits advising another economic plunge like the economic crisis of 2008. George Soros has been at the head of the pack of attack dogs and pundits warning investors to buy gold or put your savings under the mattress, now that Panama is off limits. But there will always be opportunities in every market; naysayers may be waiting outside the lines or shorting the S&P 500 or the Dow Jones Industrials, while the savvy investor who is hearing and heeding world news and making his investment choices based on what could and should be happening. It’s the rumor not the news that investors need to listen to in order to make an investment.

Here are my 5 stock picks for the second half of 2016.

General Electric (NYSE:GE)

Trading around $30, the once mighty producer of appliances for American kitchens has switched tracks and is emphasizing its Train production facility part of which is located in Erie, Pa. Erie like most of the Northeast has fallen on hard times. Once the Northeast was the production capital of the world, but the center of commerce has lost its titles to California and Silicon Valley. General Electric has not had any interest in producing computers but uses computers to design and drive its very successful train division. A company that has built an air hockey type of handling system for the movement of entire trains by one person deserves credit, a lot of credit. That process is still held in secret by G.E. and can be seen on TV but not in person. A multi-billion dollar contract was announce between G.E. and India. When a customer is an entire country, economists should realize that success beckons for the future of G.E.

A quick glance at the 5-year chart of G.E. is reassuring they have been on a an uptrend and $25. per share has been designated as a support level that has not been successfully breached since October 2013. Whenever the price action went below $25. per share it always climbed back, recovering and slowly inching upward.

Dicks Sporting Goods (NYSE:DKS)

Dick’s has established itself as a big box sports retailer with an effective Internet ordering system in place. Boys of any age like to go to any sports store while moms shop for clothes and items for the home. Dick’s covers the gamut of sporting needs, and now that Sports Authority is closing stores; Dick’s will have no competition. The two giants both were contenders but neither a titleholder, now Dick’s wins by a technical knockout.

PayPal (NASDAQ: PYPL)

$39. PayPal is everywhere and users feel secure when using PayPal. The price action of the stock has a problem topping the $40. mark; it is a strongly tested resistance, but when it breaks past $40. there will be no stopping it. PayPal represents the best of the alternative electronic pay systems and will continue to grow as it is discovered around the world. Elon Musk may be a magician on the order of Thomas Edison whose efforts started General Electric. Musk has not let success go to his head or relaxed on his extreme wealth, as he is revolutionizing aerospace at the present time. PayPal was his baby and PayPal can only continue to grow around the world as its influence is widened and felt in foreign nations.

Facebook, Inc. (NASDAQ: FB)

Nasdaq $118. Three years ago Facebook was the most controversial of IPOs. The IPO plunged to half of its suggested starting price but has since more than quadrupled in value, Facebook has withstood the test of time and new applications are bringing those past users back to the fold. What will drive Facebook is growth of computers and smart cell phones in under-developed nations. These nations have a reliance on cell phones; visit any third world country and watch teenagers and adults walk past fully focused on their cell phones. Computer use can only grow in these areas and the impact of the Summer Olympics in Rio this summer will further fuel computer and smart phone use.

American investors are part of a world economy. In the current economy any company that does not extend its borders into foreign countries will not be as successful as those that see opportunity everywhere, despite the economic conditions of the foreign country. The American economy is not only globalized but changing; retailing was once the dominant force in consumerism, but is changing from a brick and mortar based system to an Internet based ordering system. Sophisticated cell phone applications are making it possible to take a photograph of any desired item and to have the app find the product with the colors and sizes available and the location of the retailer. This app will complete the order for the user and sent it to the customer’s home. Sears and Roebucks started thinking outside the box in 1986 and with the first catalog issued in 1988 became multi-dimensional. Will Sears be able to competent in this social media frenzied world. It will be tough for Sears and it is not a pick.

Uber (Privately Held)

Uber started in San Francisco and is currently expanding explosively around the world. The third world and other less developed countries are reliant on the use of cell phones and apps like WhatsUp and Uber, and are being used by third world countries in larger numbers. Uber is a privately held company with billions of dollars in reserve, but rumor has them growing even more by the launching of a initial public offering (IPO) later this year. In this case the smart investor should be willing to buy the IPO based on this rumor and don’t hesitate; don’t wait for the news. Uber is a powerhouse of a smart phone app and will be a important player for business and as a savvy investment. This is a definite pick, a definite buy.