Traders initiate their fundamental evaluations by examining how much profit the company is making for its shareholders. The fundamental data that illustrates 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 $1 billion 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 illustrates this information is the price-to-earnings ratio, or P/E ratio.
The P/E ratio helps to determine if a share is relatively overpriced or underpriced, which is crucial. 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 the company has a prosperous future. When you are looking to buy a share, ensure the underlying businesses have real growth potential. When you are looking to sell, ensure the underlying businesses
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.
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. 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 illustrate whether current share prices are under or overpriced.
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 net income is what remains 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.