Highlights
• What is Value Investing?
• What is Fundamental Analysis
• Quantitative Metrics of a Stock/Company’s Fundamentals
• Conclusion
What is “Value Investing”?:
“Value Investing” was developed in the 1920s at Columbia Business School by finance adjunct Benjamin Graham (Warren Buffet’s mentor), and finance professor David Dodd - who co-wrote the highly acclaimed book titled “Security Analysis” in 1934. David is also the author of another famous investment book, “The Intelligent Investor”.
To put it simply, “Value Investing” is the art of identifying and purchasing stocks that are trading less than their intrinsic/book value through the use of fundamental analysis, along with other financial metrics.
Value investing starts from the premise that an investor who buys stock in a company owns part of the business. While this may seem obvious, many investors invest without doing their due diligence to the underlying fundamentals of the companies they own.
As a business owner, the investor should evaluate the financial statements of companies to assess their intrinsic values. This type of evaluation is known as fundamental analysis.
What is Fundamental Analysis?
It is the process of analysing all of a company’s fundamentals, both quantitative (cash flow, debt-to-equity ratio, etc) and qualitative (business model, competitive advantage,etc) to help determine the intrinsic or “true” value of a stock.
Practitioners of fundamental analysis believe that the current market value of a stock is not always an accurate gauge of its worth. By finding out the “true” worth of a company, investors are able to make an informed and strategic decision on whether to invest in, or even sell a stock for profits.
Fundamentals (especially quantitative fundamentals) may also vary drastically between industries. However, fundamentally sound companies do share some common qualities such as having a strong and steady cash flow, little to no debt, highly capable leadership, being a recognised brand, and a solid track record of growth.
Quantitative Metrics of a Stock/Company’s Fundamentals:
Below are the most commonly used quantitative metrics used in fundamental analysis. They are publicly available information that can be used to compare to other stocks within the same industry (different industries have different norms).
Earnings Per Share (EPS)
Earnings Per Share is a metric that tells us the company’s annual profit (less dividends paid), per share of its stock. To calculate a company’s EPS, we use the formula below:
EPS = (Earnings - Dividends) / Shares Outstanding
Price-to-Earnings (P/E) Ratio
Price-to-Earnings Ratio is a metric that tells us the current price of a share of a company’s stock in terms of its Earnings per Share. Essentially, it is what investors are currently paying for a stock today based on its past or future earnings.
This is a very important metric in discerning if an investor is currently overpaying for a stock or if said stock is undervalued. To calculate a company’s P/E Ratio, we use the formula below:
P/E Ratio = Share Price / Earnings per Share
Price-to-Book (P/B) Ratio
The Price-to-Book Ratio is a metric that compares a company’s market capitalisation to its net value (assets - liabilities). This metric is a good indicator of what investors are willing to pay for each dollar of a company’s net value. To calculate a company’s P/B Ratio, we use the formula below:
P/B Ratio = Share Price / Net Value per Share
Debt-to-Equity (D/E) Ratio
The Debt-to-Equity ratio is a metric that compares a company’s liabilities (total debt) to its shareholder equity, to determine how its operations and asset maintenance is being funded - be it internally or externally.
A company’s stock may be deemed a risky investment if it is incurring too much debt relative to its earnings or cash flow to meet its functional costs. To calculate a company’s D/E Ratio, we use the formula below:
D/E Ratio = Liabilities / Shareholder Equity
Projected Earnings Growth (PEG) Ratio
The Projected Earnings Growth Ratio is a metric that compares a company’s P/E Ratio to its growth rate. It provides a clearer picture of a stock’s value by comparing today’s earnings with its expected growth rate.
As a rule of thumb, a stock with a PEG Ratio of less than 1 is considered undervalued and vice versa. To calculate a company's PEG Ratio, we use the formula below:
PEG Ratio = P/E Ratio / Growth Rate
Free Cash Flow (FCF)
The Free Cash Flow metric is essentially the cash produced by a company’s operations less its expenditures to maintain those operations and also capital expenditures (CapEx).
It is an important metric in determining how efficient a company is at generating income and to determine whether a company has sufficient spare cash to reward shareholders through either dividends or share buybacks.
Dividend Yield
Dividend Yield is essentially a percentage of a company’s stock price that is paid out annually (frequency may vary among companies) to each shareholder in dividends. To calculate a company’s Dividend Yield, we use the formula below:
Dividend Yield = Dividend Paid per Share / Share Price
Dividend Payout Ratio
Dividend Payout Ratio on the other hand is the percentage of income a company pays to its shareholders in the form of dividends. To calculate a company’s Dividend Payout Ratio, we use the formula below:
Dividend Payout Ratio = Dividends Paid / Total Earnings(income)
Return on Equity (ROE)
Return on Equity is simply the comparison between a company’s total earnings (income) to its shareholders’ equity within a period. To calculate a company’s Return on Equity, we may use the formula below:
ROE = Net Income / Shareholder Equity
Conclusion
You may calculate a company’s quantitative fundamentals using publicly available quarterly or annual company statements and reports. They can also usually be found by simply doing a google search with the company’s name followed by the metric in question (e.g, “Google P/B Ratio). In the next article, I will be talking about the other side of the coin - qualitative analysis.
I hope you have enjoyed this one, and as always, stay safe and may the markets be ever in your favour.
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