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Introduction to Fundamental Analysis Income Statement Analysis Balance Sheet Analysis Cash Flow Analysis Shareholders' Equity Analysis Ratios and Definitions

Income Statement Analysis

 - Great companies and good
    EPS growth do not guarantee
    stock market profits

 - The P/E ratio can create
    buying opportunities

 - Mishaps can create steals

 - Unusual charges reduce the
    value of your stock

 - ROE is the single best tool
    for investors

 - ROA is another valuable tool

 - Investors pay for high profit

 - Lenders can eat up all the

 - Depreciation creates
    deferred taxes, which have
    equity-like qualities

 - EPS is a complicated



The P/E ratio can create buying opportunities

The price earnings ratio (“P/E ratio”) is the multiple of EPS that a stock sells for. It is calculated by dividing the share price by the annual earnings per share (“EPS”) of a company.

The P/E ratio is, by far, the most widely used valuation tool in stock investing. There are, however, nuances that should be understood when evaluating P/E ratios. The biggest drawback in using the P/E ratio is that it ignores the balance sheet, cash flow, and business cycle of a company. Below is a discussion of these drawbacks:

·        The Balance Sheet – While the quality and financial management of the balance sheet is vitally important to the overall returns of an organization, it is ignored by the P/E ratio. Leveraged, highly indebted companies, must eventually pay back their lenders. Therefore, profits and other financial resources, which would have been used to increase shareholders’ value, are instead going to the lenders to pay back debt. All things being equal, companies with less debt have more opportunities to increase shareholder wealth, than companies with more debt. The P/E ratio narrowly focuses on earnings and ignores the opportunity potential of the balance sheet. 

·        The Cash Flow Statement – Two companies with the same EPS and stock price, can have significantly different cash flows, affecting the overall long-term returns of these companies. Yet, again, the P/E ratio also ignores cash flow. Ironically, it’s cash flow that builds wealth, not accounting income.

·        The Business Cycle – The P/E ratio also disregards a company’s business cycle. The business cycle reflects the company’s earnings fluctuations within long-term economic trends. Companies can have big swings in earnings, depending on where they are in their business cycle. Coming out of a slow down, as earnings ramp up, the P/E ratio is usually high; conversely, going into a slow period, as the stock price drops, historical earnings may still be high, resulting in a low P/E ratio. There is a timing gap, for cyclical companies, between the direction of earnings and the P/E ratio.  P/E ratios, therefore, are lagging indicators on the direction of earnings.

Additionally, there is an inverse correlation between inflation, interest rates, and P/E ratios.

Computationally, the ratio compares historic EPS to the current share price. Relying on the factual ratio can be misleading, if there are current year changes in the company’s financial performance. In such cases, Investors need to recalculate the ratio, using the current year or subsequent year EPS, not the prior year results. EPS is also affected by unusual and non-recurring P&L items. Updating and using proforma data adds value to the P/E ratio and can give the investor a slight edge. Current earnings estimates are readily available on the internet; Bloomberg.com and Zacks.com are good sources.  

Normally, the higher a company’s P/E ratio, the greater its growth potential. The best use of the P/E ratio is in the comparison of companies in the same industry.  Comparing the P/E ratios of different industries is also a valid approach, but can be somewhat tricky. One should not, for example, compare the P/E ratio of a drug company with that of a bank. First of all, drug companies have completely different earnings models than those of banks. Secondly, banks should be valued based on book values, not P/E ratios.

What is a fair P/E ratio?  Value investors should look for a company whose normalized P/E ratio is equal to or less than its growth rate. Momentum players pay more. Everyone “chases the cheese” differently. Nonetheless, always compare the company’s price earnings ratio to its growth rate, to gauge the premium or discount you are paying or receiving.

When analysts and newswriters use price-to-sales ratios to determine value, watch out! This is a cue to avoid the stock; you pay for earnings or cash flow, not for sales.

Further complicating the P/E ratio are the effects of mergers and acquisitions. Recently, private equity firms have purchased a significant portion of publicly traded equities. The reduced supply of equities may result in a P/E expansion for the remaining companies.

The intricacies of the P/E ratio can hide the true underlying earnings of a company, thus creating buying opportunities for the astute investor.




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