Investing in Shares

Introduction to Fundamental Analysis

Australian Shareholders Association

Tutorial Resource Library

Disclaimer

• The ASA is not licensed to give financial advice.

• The content of these presentations is not designed to provide any specific investment advice to any person present.

• The ASA does not accept any responsibility to inform you of any matter that subsequently comes to our notice that may affect any of the information discussed.

• Anyone wishing to act on any matter discussed should seek independent advice from a licensed financial adviser.

Outline

• What is Fundamental Analysis

• What is involved

• Pro’s & Con’s

• Company information

• Financial Ratios

• Research & Analysis

• Filtering using fundamental data

What is Fundamental Analysis

Fundamental analysis attempts to determine the value of a company by analysing the financial data from the annual report and other qualitative data about the company and environment in which they operate.

Fundamental analysis is based on the idea that if the ‘basics’ (or fundamentals) of a stock are right, it’s most likely going to be a good long term investment regardless of short term price fluctuations.

What’s involved in Fundamental Analysis?

• Company information

• Financial Ratios

• Research & analysis

• Dividend history

• Directors & dealings

• News & announcements

• Shareholder Information

...... Plus a whole lot more!

This presentation will provide an overview of the first three topics listed here.

Pro’s for Fundamental Analysis

Area Basis

Objectivity Uses sound mathematical and statistical principles to produce ratios so that there is no room for personal bias

Long Term Focus Markets are usually drive by fundamental factors over the long term. Fundamental analysis can look at long term economic, demographic, technological or consumer trends

Value ‘Crunching the numbers’ theoretically should lead an investor to buy at a prices that are deemed ‘good’ value

Increased Understanding Doing the research into the fundamentals provides the investor with a better understanding of the company and its business

‘Sleep at Night’ Factor Investors know that they are investing in fundamentally sound companies because they have done their ‘due diligence’ analysis

Con’s for Fundamental Analysis

Area Basis

Time Consuming Fundamental analysis can be hard work and complicated. Give the time and difficulty constraints it may be more difficult to get an ‘edge’.

Market Sentiment In the short term, markets will not always move in the same direction as fundamental value meaning that often short term momentum or market sentiment will over ride the fundamentals

Timing Six monthly issuing of financial information may mean a company’s fundamentals have significantly changed and means a time lag for investment decisions.

Based on Assumptions Fundamental analysis for future estimated value can only be based on assumptions so a best and worst case valuation model may need to be considered. No valuation model can take into account any unexpected negative economic, political or legislative changes. Information comes from the company itself so assumptions have to be made that the company is providing accurate and true information

Fundamental Analysis – How can I use it?

Fundamental analysis provides key information on which stocks have the best value and should be profitable ....

.... but it may not be the best tool to use to determine when to buy a particular stock.

Company Information

When an investor looks to invest in a company they might consider:

• Company profile – size, age, history, location, segmentation, structure

• Management – track record, experience, compensation model, independence of directors, succession planning, director and management shareholding levels

Company Information

Investors can obtain general information about companies from a range of sources including newspapers, the internet news sources, broker website and the company websites.

Investors will need to apply a more subjective approach to this type of qualitative information. This may mean:

• Reading as much as possible about the company • Considering opinions of experts analysts • Reading company reports and listening to

management when they report to the market

Financial Ratios

A large part of fundamental analysis is looking at a company’s financial ‘health’ to help the investor determine the financial risk of making an investment in a particular company.

To determine financial ‘health’ an investor would consider the key financial ratios of the company or companies they are interested in.

Key Financial Ratios

Financial ratios and investor could analyse are:

• Price Earnings Ratio (P/E)

• Price Earnings Growth Ratio (PEG)

• Debt to Equity (D/E)

• Return on Equity (ROE)

• Return on Assets (ROA)

• Dividend Yield (DY)

• Market Capitalisation (Market Cap)

Price Earnings Ratio (P/E)

Generally, a low P/E is better than a high P/E • Growth companies will often have higher

P/E’s • Enables comparison between similar

companies & to market/sector averages • Some drawbacks including dependence upon

price which is based on market sentiment

Measures the time it would take for an investor to recoup their initial outlay in the form of return

P/E – How is it Calculated?

PE Ratio = Share Price Earnings Per Share

e.g. $1.00 share price = PE 10 10 cents earning per share

$1.00 share price = PE 5 20 cents earning per share

Price Earnings Growth Ration (PEG)

Useful as a check on whether a P/E is justified or not

• PEG of 1 is seen to be fair value • PEG of greater than 1 indicates a more

expensive stock

PEG – How is it Calculated?

PEG Ratio = P/E Ratio Growth Rate in %

e.g. PE 10 = PEG 1 10% Growth PE 20 = PEG 2 10% Growth PE 10 = PEG 0.5 20% Growth

Debt to Equity (D/E)

Measures a company’s financial leverage and indicates what proportion of equity and debt the company is using to finance its assets

• Generally a company that has a D/E ratio of greater than 40% or 50% should be analysed more closely.

D/E Ratio = Long Term Debt x 100 Shareholders Equity

Return on Equity (ROE)

• The higher the ROE over a reasonable period the better, and ROE should be steady or rising

• High ROE should enable a company to pay a good dividend and also put back funds into the company for growth

• Good indicator for overall performance

• Can be compared with returns from other investments

Measures the return a company achieves with shareholders' funds

ROE – How is it Calculated?

ROE = Net Profit x 100 Shareholders Equity

A ROE of 10% to 20% indicates healthy growth

Return on Assets (ROA)

Measures how profitable a company is relative to its total assets as it gives an idea as to how efficient management is at using the assets of the company to generate earnings

The higher the ROA, the better as it means that the company is earning more earnings with less assets.

Can also be used to show if a company is asset intensive i.e needs high value assets to generate a profit.

ROE = Net Income x 100 Total Assets

Dividend Yield (D/Y)

Measures the return in income an investor gets from a share

• Fluctuates with share price • Can be compared with returns from other

investments

• Can be grossed up by adding back the franking credits

• Need to be careful of artificially high yields

D/Y – How is it Calculated?

Div Yield = Dividend per share x 100 Share Price e.g. 5 cents per share = DY 5% $1.00 per share $1.00 share price = DY 2% $50.00 per share

Market Capitalisation

Measures the value that the market puts on the company

Generally, the higher the market capitalisation, the more liquid the stock that is the easier it is to enter and exit a stock in a meaningful parcel size

Market Cap = Number of shares outstanding x Share Price

Research & Analysis

Some investors may think that they need to be an accountant to understand the financial ratios. However, on line research tools summarise the information in a way that is easily understandable.

Once you understand what different ratios measure you can then begin to evaluate different stocks in an objective way.

Research

Here are some screen shots of company financials from a popular broker.

The table below provides comparisons of current ratios to both the market and the sector

While this table above shows history for various statistics going back for a 10 year period

And this table below looks at current earnings and dividend forecasts

Analysis Approaches

Investors can take two approaches to evaluating financial statistics and often these two approaches can be successfully combined in the decision making process.

• Snapshot Approach – look at ratios at a given point in time and compare them to ratios of other stocks to obtain meaningful comparisons.

• Trend Approach– look at how the ratios are changing for one particular stock over a period of time.

For example you may look at the P/E ratio to compare two stocks to get an idea of which stock may be less expensive and then you might review earnings for your favoured stock over the last 5 years to ensure earnings are growing.

Using Fundamental Filtering Criteria

Another useful way to use financial ratios is to filter stocks on a set of criteria that you consider important to gauge the financial ‘health’ of a company.

Consider the following set of fundamental criteria: • PE less than 16 • PEG less than 1.1 • DY greater than 4% • ROE greater than 12% • Market Cap greater than $50,000,000

Fundamental Search

Find your brokers fundamental search function. For Commsec it is located under the Quotes and Research tab and then by selecting Company Search from the left hand menu

PE < 16

• Once in company search, select Value from the Category drop down list, find the P/E ratio from the Field drop down list, selection Less than as the Option and type 16 in the Value box.

• Make sure you press the Add Criteria button so that your PE criteria is added to your search.

PEG < 1.10

Still in the Value Category, select P/E Growth ratio from the drop down menu, select Less than in the option box, and type in 1.1 in the value box

Select Add Criteria

See each criteria get added to the Search Criteria box at the bottom of the screen

D/Y > 4%

Select Income from the Category drop down menu, Select Dividend Yield from the field drop down menu, select greater than and then type in .04 (This equals 4%)

Click the Add Criteria button

ROE > 12%

Select Performance Measures from the Category drop down menu, Select Return on Equity, Select Greater than and type in 0.12 (= 12%)

Select the Add Criteria button

As you can see, we have four of five fundamental criteria here so far

Market Cap > $50Million

Select Company Statistics from the Category drop down menu, select Market Cap, select Greater than and type in 50,000,000.00 in the Value box

Select Add Criteria

We are now ready to run the search – Select the Search button below the Search Criteria

Search Result

For this search our criteria found 26 results – of course your search will be run at different times so each search will return a different result

We can now take our search results and do further qualitative and quantiative fundamental research or look at technical analysis factors.

Summary

• Looking at fundamentals and requiring a company’s financial ratios to be at a certain level is a way of ensuring that shares that you consider for purchase are financially ‘healthy’.

• Fundamental ratios can be used to compare stocks

• Fundamental analysis may not be the best tool to time entry into stocks

ASA Learning

To find out about other learning resources available to investors, explore the ASA’s

Investor Education Pathway