GET Financial Education Series - Stocks and CFDs
Company Fundamentals – Lesson 6
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Company fundamentals - such as how much money the company is earning and how efficiently the company is utilising its resources - drive the share and CFD markets. Traders want to buy companies that they believe are going to continue growing, and they want to sell companies that they believe are going to stop growing. Stock and CFD traders also want to buy companies that appear to be undervalued. Learning a few basic fundamental concepts and what information professional traders are looking at will help you to accurately predict which way the market is likely to move in the future.
Company fundamentals wax and wane as the moon does, and consequently shares and CFDs ebb and flow like the tide. As the fundamentals for a company get stronger the tide comes in, in effect, the company's ships come home on it, and this raises the value of that company's share price. Yet, whenever the fundamentals for a company weaken, it is like the tide going out and, with it, there's a lowering of the value of that company's share.
In this section we will highlight the following categories of fundamental information. Company fundamentals wax and wane as the moon does, and consequently shares and CFDs ebb and flow like the tide. As the fundamentals for a company get stronger the tide comes in, in effect, the company's ships come home on it, and this raises the value of that company's share price. Yet, whenever the fundamentals for a company weaken, it is like the tide going out and, with it, there's a lowering of the value of that company's share.
Traders tend to focus their attention on a few different fundamental numbers when they are evaluating a company. All of this fundamental information, and more, is available to you as a share and CFD trader. You have access to the same information the professionals use to make their buying and selling decisions. By taking the time to learn about a company's fundamentals you can better determine which direction a company's share price should move in the future, and that should allow you to take advantage of those movements in your trading.
In this section we will highlight the following categories of fundamental information.
- Earnings
- Operating efficiency
- Cash flow
Company Earnings
Share and CFD traders tend to begin their fundamental evaluations of companies by looking at how much money the company is making for each of its owners. After all, when you buy a share you become an owner of the company - so naturally you would be concerned about how much money the company is making for you.
The fundamental piece of information that tells share and CFD traders how much money the company earned for each owner is called earnings-per-share, or EPS. To arrive at this number traders look at the overall earnings for the company and divide that number by the number of shares the company has issued. If a company earns BJ1 billion and has 1 billion shares issued, the company will have an EPS of BJ1.
Once share and CFD traders identify a company's EPS, they then look at how much a share costs compared to the earnings that are associated with each share. The fundamental ratio that tells traders this information is the price-to-earnings ratio, or P/E ratio.
The P/E ratio gives share and CFD traders an idea of whether a share is relatively expensive or inexpensive, which is crucial because traders looking to buy shares and CFDs are looking for inexpensive shares. For example, if a share has an earnings-per-share, or EPS, of BJ1, and the share is trading for BJ20, then it has a P/E ratio of 20. By looking back to see what P/E ratios the share has had previously, traders can see if the current P/E ratio of 20 is comparatively high or low.
Traders are also interested to know if the company is going to increase earnings in the future. Good earnings today are all well and good, but traders want to know if the company can continue growing. in the future - past growth is no guarantee of future growth.
Luckily for retail investors you do not have to do all of the work on your own to determine if a company has good growth prospects. Large financial institutions employ armies of analysts to carry out research on companies, the industries they belong to, and how they will respond in current and future market conditions, and many of the findings from these analysts are available to the investing public on a delayed basis.
When you are looking for shares and CFDs to buy, make sure the underlying companies are projected to grow. When you are looking for shares and CFDs to sell, make sure the underlying companies are projected to experience slow growth or no growth.
Operating Efficiency
Once share and CFD traders have evaluated how much money a company is earning for its owners, they tend to move on to looking at how efficiently the company is utilizing its resources. Shares in efficient companies tend to perform much better than shares in inefficient companies, because efficiency generally leads to greater profitability and more earnings flowing into share and CFD owners' pockets. Of course, what is considered efficient in one industry (like transportation) may not be considered efficient in another industry (like healthcare) so it is important you become familiar with the industry norms for any company your are evaluating.
One of the resources that traders are most interested in seeing used efficiently is shareholder equity. Shareholder equity is all of a company's cash, hard assets and retained earnings (those company earnings that the company keeps to invest instead of immediately distributing to shareholders). Traders are interested in shareholder equity because, if a company can't efficiently use the assets that belong to the share holders, the shareholders would rather see their assets put to work somewhere else.
To monitor how efficiently their assets are being utilized, shareholders make a comparison in respect of shareholders' equity that is similar to the comparison they make with the price of the share compared to the earnings of the company in the P/E ratio. The comparison they make is called the price-to-book ratio.
Here's how it works, suppose you have two piggy banks and both are being sold for BJ100. However both piggy banks are not the same. Inside the first piggy bank you will find BJ100 whilst inside the second piggy bank you will only find BJ10. Which piggy bank would you rather buy for BJ100? You would obviously want to buy the piggy bank with BJ100 in it. Looking at a company's price-to-book ratio is a similar concept.
To find a company's price-to-book ratio, you first have to determine the book value of the company. The book value of the company is equal to the shareholders' equity divided by the number of shares the company has issued. If a company has BJ5 billion in assets and issued a total of 1 billion shares, the company has a book value of BJ5 per share. That is how much money is inside the piggy bank per share. Next, share and CFD traders divide the current share price by the book value to determine the price-to-book ratio. If the share was trading at BJ20, it would have a price-to-book ratio of 4.
Like the P/E ratio, the price-to-book ratio can give you an idea of whether the current share price is expensive or not.
Cash Flow
Cash is a company's life-blood. Regardless of how well a company is performing otherwise, if it runs out of money it will cease to function. A company must have cash to pay its employees, its vendors and its shareholders - whether it is paying the cash out as a dividend or keeping the cash in retained earnings to grow the company and increase the value of the share.
Some traders look at a company's bottom line, its net income, and assume that number represents the amount of cash the company generated. Net income is supposedly what is left after you subtract your expenses from your revenues. But that is not exactly the case.
Net income is the value the government uses to determine how much in taxes a company owes each year. However, governments want companies to grow and expand so they can boost the economy and provide jobs. With this end in mind, governments provide companies with incentives - such as depreciation and interest deductibility - to entice them to grow and expand. These incentives are accounted for as companies calculate their net income figures.
Traders are more interested in how much cash a company can create than they are in a company's earnings after all of the adjustments are accounted for. They therefore like to look at a company's free cash flow. Free cash flow represents a company's true cash flow - how much cash a company has available to invest in new initiatives or to pay to investors via dividends. To find a company's free cash flow you identify the company's net income, add its depreciation and amortization expenses back into that number, and then subtract the company's changes in working capital and capital expenditures from the balance.
| |
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 determine if a company's share price is expensive or inexpensive compared to the cash the company is able to generate.
Company Earnings
