So what do Warren Buffett and Peter Lynch have in common?
Aside from being legendary investors, neither one of them has ever used technical analysis to dig up a market-beating stock pick.
In a world bereft of charts, trend lines, and candlesticks, both of these heavy weights have relied entirely on fundamental analysis to earn their famous fortunes.
In fact, their disdain for technical analysis is so complete that Buffett once remarked, "I realized technical analysis didn't work when I turned the charts upside down and didn't get a different answer."
Meanwhile, Lynch once observed, "Charts are great for predicting the past."
Instead of focusing on market momentum, they simply concentrated on finding long-term value. It's called fundamental analysis.
And over time, that singular "system" made both men very wealthy.
So What is Fundamental Analysis?
Simply put, fundamental analysis – at its core – entails using real data to arrive at stock's intrinsic value. Part qualitative and part quantitative, this method analyzes the financial data that is 'fundamental' to a company's future prospects.
As such, fundamental analysts make their investment decisions based largely on:
- A company's competitive advantage
- A company's earnings growth
- A company's sales revenue growth
- A company's market share
- A company's financial reserves
- A company's product pipeline
- The quality of the company's management
In doing so, fundamental analysts focus on a company's financial statements and profit by finding gems that the market has mispriced.
When a stock is underpriced, they buy; when it's overpriced, they sell short.
Sounds simple enough, right?…
Tools for Fundamental Analysis
But what exactly do these gurus look for as they as they pour through 10-ks and balance sheets?
To them, it's 80% about the numbers…
The following list includes the eight metrics they use as a starting point to screen for undervalued gems.
1. Earnings: First and foremost, it is a "bottom line" affair where everything else flows from how much money a company earns after subtracting expenses. Earnings are important to investors because they give an indication of the company's expected dividends and its potential for growth and capital appreciation.
2. Earnings Per Share: Net earnings, however, are only part of the story, since they don't take into account how many shares of stock are outstanding. In order to make earnings comparisons more useful between a set of stocks, fundamental analysts also look at a company's earnings per share (EPS). EPS is calculated by taking a company's net earnings and dividing by the number of outstanding shares of stock the company has. For example, if company XYZ reports $20 million in net earnings for the previous year and has 5 million shares of stock outstanding, that company has an EPS of $4 per share. That would make the stock worth more than a similar company with an EPS of $2 per share, assuming everything else is equal.
3. P/E Ratio: While this is not the holy grail that some investors think it is, P/E does give you a window into how the market prices specific securities historically. It's calculated by taking a company's price per share (P) and dividing by its earning per share (E). For instance, if a stock is priced at $50 per share and it has an EPS of $5 per share, it has a P/E ratio of 10. The higher the P/E, the more the market is willing to pay for each dollar of annual earnings. Of course, companies that don't have earnings have no P/E ratio at all – which is why you'll rarely find a fundamentalist anywhere near them.
4. PEG Ratio: So, is a stock with a high P/E ratio always overvalued? Not necessarily… That's because P/E doesn't take earnings growth into account. That's where a company's PEG ratio comes in. PEG is calculated by taking a stock's P/E ratio and dividing by its expected percentage earnings growth rate – typically for the next five years. A stock with a P/E ratio of 50 that's expected to grow its earnings by 30% would have a PEG of 1.66. In general, the lower the PEG; the better the value. This is because you would be paying less for each unit of earnings growth. Companies with PEG ratios of 1 or less are usually bargains.
5. Dividend Yield: Not surprisingly, fundamental investors love dividends. The dividend yield measures what percentage return a company pays out to its shareholders in the form of dividends. It's calculated by dividing the dividends you receive over a year's time by the price you paid for the stock. For example, your dividend yield is 5% if you paid $20 per share, and you receive $1 per share in dividends ($1/$20) over the 12 months following your purchase. In short, it is a cash payout that you receive for simply being a shareholder- sort of like receiving a bonus based on a company's earnings.
6. Debt/Equity Ratio: In general, value investors frown upon companies with high levels of debt. Instead they prefer earnings growth that's generated by shareholder equity, as opposed to borrowed funds. It's a measure of a company's financial leverage calculated by dividing its total liabilities by stockholders' equity. It indicates what proportion of equity and debt the company is using to finance its assets. In this case, the higher the ratio, the more debt that a company carries. And while this figure varies from industry to industry, a good way to measure it would be by looking for a ratio that is less than 80% of the industry average.
7. Book Value: The book value of a company is the company's net worth, as measured by its total assets minus its total liabilities. This is how much the company would have left over in assets if it went out of business immediately. Value investors often look for companies trading "under book".
8. Return on Equity (ROE): Return on equity (ROE) shows you how much profit a company generates in comparison to its book value. The ratio is calculated by taking a company's after-tax income (after preferred stock dividends, but before common stock dividends), and dividing by its book value. It is used as a general indication of the company's efficiency; in other words, how much profit the company is able to generate given the resources provided by its stockholders. A good ROE in this regard would be a 5-year average between 15%-17%.
But, of course, these are just starting points on the way to calculating a company's intrinsic value.
Fundamental investors also consider things such as its brand-name recognition, patents, or proprietary technology.
Those are the less tangible aspects about a company that are all part of your "due diligence" as an investor.
In short, it's the final 20%– the part that often separates the winners from the losers.
Because let's face it, Peter Lynch nailed it when he said, "Investing without research is like playing stud poker and never looking at the cards."
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