Fundamental Analysis is a vast topic and short article is certainly not enough to give it the full attention it deserves. Fundamental analysts, in the simplest of terms, attempt to identify the intrinsic value or fair value of an asset. From the economic theory perspective, fair value of an asset is where supply and demand intersect. Let’s explore the common fundamental analysis technique of Price to Earnings (P/E) Ratio
Benjamin Graham, the man who is known as Warren Buffett’s mentor and is hailed as the “Father of Value Investing”, developed this metric. Companies can be compared by using P/E ratio -
Share Price / Earnings per Share (EPS)
Share price represents market value per share, the price that you need to pay right now to buy one share of a company. EPS is an accounting metric and it is calculated as (Net Income – Dividends of Preferred Stock)/Average Common Shares.
Let us put it in simpler terms. Share price represents how much the market thinks one share is worth, while EPS represents how much income (that can be distributed to ordinary shareholders) is actually generated by a company. Therefore, P/E ratio shows us how much a trader is paying for $1 or £1 or €1 of a company’s earnings.
Different industries have different “normal” ranges for P/E ratios. For example, technology companies usually have P/E ratios of 20 or more, while manufacturing companies will have average of 10 and less. This tells us that the market recognises the greater earnings potential of technology companies. It is also important to analyse the growth potential of a company, so analysts usually compare P/E ratios with peer group. Some analysts additionally use PEG ratio to analyse EPS growth as well.
We find it useful to explore some fundamental techniques, and their benefits and drawbacks, but it is important to remember that relying on fundamental analysis alone is quite risky for the inexperienced traders, and you have to consider a vast number of variables. Therefore, we prefer to use technical analysis in order to develop your trading techniques.