Introduction to Fundamental AnalysisLauri08/11/2012

What is Fundamental Analysis?● Method of valuing securities such as stocks and

bonds● Attempts to find out their intrinsic (true) values● If undervalued → Long (Buy)● If overvalued → Short (Sell)

EXAMPLE 1 : Slot Machine● Jack buys a £1 500 Poker

Machine and takes £1 000 loan at 5% annual interest rate

● He places the machine to a local barber shop and promises to give 20% of the earnings to the shop owner

● The machine starts earning him £300/month

● How much is Jack's business worth? £500? £1000? £1 500?

Some Ratios

● P/E ratio (price-to-earnings ratio)- How long it takes that the investment pays itself back

- Market Price per Share* / Annual Earnings per Share (EPS)***EPS = Net Earnings / Number of Shares**Market Price = Market Capitalisation

● P/B ratio or PBV (price-to-book-value ratio)- How much tangible asset (+ goodwill) you get for the money you invest- Market Price per Share / Book Value per Share***

***Book Value = Value of Total Assets

More Terminology● (Shareholder's) Equity = Assets – Debt● Net Gearing (%) = Net Debt / Equity● EBITDA = Earnings before interest, taxes,

depreciation (e.g.repairs), and amortisation (e.g.patents,copyrights)

● EBIT = Earnings before interest and taxes● Net Income/Profit = Earnings after taxes● Dividend Yield (%)

= Dividend per Share / Market Price per Share● Dividend Payout Ratio(%) = Dividend per

Share / EPS

Some More Ratios● Profit Margin (%) = Net Profit / Net Sales● Return on Equity (ROE) (%)

- Annual increase in shareholder's equity

- ROE = Net Income (After Tax) / Equity- Double ROE → Double P/E

● Return on Assets (ROA) (%)- ROA = Net Income / Total Assets

● PEG Ratio (Price/Earnings-to-growth)- PEG = (P/E) / (Annual EPS Growth)- e.g.company growing 30% a year with P/E=30 → PEG=1

EXAMPLE 2 : More Slot Machines

● What if Jack invests all his earnings to new Poker Machines and places the machines in new barber shops?

● What if we take into account the risk that hooligans break his machine?

Top-Down Stock Selection● World View

- Recognising the trend using e.g. leading indicators (building permits, UMCSI)

● Industry View- Which sectors are going to thrive given the world view?

● Business View- Which stocks within the industry are most suitable based on their ratios and our world view

Rules of Thumb (by Peter Lynch)● Market Cap < £5 billion● PEG ratio < 1.2 (PEG=1 is fair

value)● Earnings Growth > 15%● Gearing (Debt Ratio) < 35%● Institutional ownership < 65%● Pays Dividend● Not a penny stock● Careful with cyclical stocks

(e.g. construction, automobile)

Questions?