4 Fundamental Indicators I Use in Fundamental Analysis
By: Tunji Onigbanjo
Tags: Money, Education, Finance, Investing, Stock Market

1. Earnings Per Share (EPS)

EPS is a company’s net income divided by the outstanding shares of its common stock. On Yahoo Finance, it is visible under Financials → Income Statement of a company’s page. EPS is an indicator of a company’s profitability, meaning the higher a company’s EPS is, the more profitable the company is considered. In the calculation of EPS, it is common to use the weighted average number of common shares instead of the actual number of common shares due to the number of common shares changing over time. For example, if Company A has a net income of $20,000,000 and the weighted average of common shares is 2,000,000, it has an EPS of $10. If Company B has a net income of $40,000,000 and the weighted average of common shares is 5,000,000, it has an EPS of $8. Strictly focusing on EPS, Company A is considered more profitable than Company B. This example showcases Basic EPS.

There are other forms of EPS that allow for a more granular view of how profitable a company is. There is Diluted EPS which assumes all shares of a company that could be outstanding have been issued. This means that if a company has preferred stock and convertible securities, those are considered a part of the outstanding shares of common stock. There is also Adjusted EPS, which excludes extraordinary items such as one-off purchases or sales by a company. An example is a company that owns factories to produce hammers selling a factory, which produces income for them. The income made from selling this factory would not be considered in the net income of a company for Adjusted EPS since this is a one-off sale.

I focus on Basic EPS. It gives me a quick look at the profitability of a company. With the Basic EPS of a company, it is best to compare it to its peers. For example, you would compare Amazon’s EPS to the EPS’ of Alibaba, eBay, JD, and Walmart because they are peers. EPS is a useful tool to get a glance at the performance of a company, but it has limitations. EPS does not consider share price, meaning that it does not give a clear indicator of future growth for a company even if they have a high EPS now. Therefore, EPS is a major component of the next fundamental ratio, price-to-earnings ratio.

2. Price-to-Earnings Ratio (PE Ratio)

PE ratio, commonly referred to as just PE, is the ratio for valuing a company’s current share price versus its EPS. On Yahoo Finance, it is visible under Statistics → Valuation Measures of a company’s page. For example, if Company A has a share price of $50 and an EPS of $5, its PE is 10. A high PE commonly means that a company’s share price is overvalued unless significant growth is expected for that company. An example of a company that has a high PE ratio is Zoom, which currently has an extremely high PE of 1,660. This showcases that Zoom is overvalued unless they continue to achieve significant amounts of growth in the future. A low PE is the opposite and a company that has no earnings at all, meaning that it is likely losing money, will not have a PE at all.

PE is commonly categorized into two categories, trailing and forward. Trailing PE is calculated by dividing the current share price by the trailing EPS for the past 12 months. Trailing PE is useful in comparing earnings between different periods for a company and for comparing earnings between a company and its peers. Forward PE is calculated by dividing the current share price by estimated future EPS for the next 12 months. Forward PE is useful in making future earnings growth judgments for a company.

I focus on Trailing PE. It is simpler and I do not have to worry about biased results due to it using actual data, unlike Forward PE. I utilize Trailing PE to compare a company’s growth over time and see how it has performed compared to its peers. Trailing PE is a useful fundamental indicator, but it is limited in the sense that the share price must be fixed to a certain date. It is also limited because a company’s past performance is not a firm indicator of future performance.

3. Price-to-Book Ratio (PB Ratio)

PB ratio, commonly referred to as just PB, is the ratio used to compare a company’s market price to its book price. Book value is any value entered by a company on its books. On Yahoo Finance, it is visible under Statistics → Valuation Measures of a company’s page. It is calculated by dividing a company’s market value per share by its book value per share. For example, if Company A has a market value per share of $50 and a book value share of $52, it will have a PB of 0.96. PB is used by investors who focus on value to identify potential investments. Value investing involves picking companies to invest in that are trading less than their book value. Fundamentally, a PB less than 1 is considered a solid investment, which means that the company is undervalued. Company A with a PB of 0.96 can be considered a solid investment.

PB tends to be higher than 1 for most companies due to market value typically being higher than what a company values itself on its books. Realistically, a PB under 3 showcases an undervalued security that has the potential of being a solid investment. I focus on PB for companies that are not in the technology sector since technology companies have higher PBs’ due to their significant growth over time. PB is useful due to the book value of a company’s share being a stable metric that can be easily compared to the market value of a company’s share, but it is limited in the sense that a recent event like a share buyback can distort PB, making a company seem more undervalued or overvalued. A company’s book value per share will increase in a share buyback if the market value per share is less than the book value per share before the repurchase, which can make a company seem more undervalued. A company’s book value per share will decrease in a share buyback if the market value per share is greater than the book value per share before the repurchase, which can make a company seem more overvalued.

4. Return on Equity (ROE)

ROE is a measure of a company’s financial performance calculated by dividing net income by average shareholders’ equity. Shareholders’ equity is equal to a company’s assets minus its liabilities. On Yahoo Finance, ROE can be found under Statistics → Management Effectiveness of a company’s page. ROE measures how effectively management is using the assets of their company to generate profits. For example, Company A’s 2019 ROE can be calculated by dividing a net income of $50,000,000 by an average shareholders’ equity of $200,000,000, which equals to 25%. Let us say that their ROE was 15% in 2018 and 12% in 2017. This shows that Company A has become more efficient at generating profits over time. Also, let us say Company A peers, Company B and Company C, have a 2019 ROE of 21% and 19%. This shows that Company A’s management has been more efficient in generating profits in 2019 than Company B’s and C’s management. The higher the ROE, the better the company is considered regarding its ability to generate profits.

With ROE, I like to do similar practices as stated in the example above. The ROE of a company is best used when it is compared to its industry or peers. ROE is a useful measure, but even when a company has a high ROE, that does not mean that the company has been perfect at generating profits. A high ROE, such as Company A’s ROE being 27% and Companies B and C having ROEs of 14% while the industry average is 12%, is only good if net income is significantly larger compared to equity due to the company’s extremely strong performance. If that is not the case, then a high ROE only indicates that a company has a small equity account compared to net income, which showcases risks, such as being over-leveraged and inconsistent profits. On the extreme flip side, a negative ROE is likely due to a company having a net loss or negative shareholders’ equity, which means that ROE cannot be used to analyze the company since it does not show anything of value.