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.
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.
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.
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 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 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.