The Fundamentals of Fundamental Analysis

Oak Haven Investments

July 21, 2005

Investing is buying a share of a company’s success and/or failure.

Pretend that you can buy into someone's income.

You are given the opportunity to choose one of five people to “buy into”.

What would you want to know about each person?

Person 1 – Lew (all people and situation are purely fictional)

Retired Monthly Fixed Income If you divide his yearly income by the number

of shares available you come out with $1/share

Earnings Per Share (EPS) = $1

Lew’s EPS

0

0.05

0.1

0.15

0.2

0.25

2001 2002 2003 2004

1st Qtr

2nd Qtr

3rd Qtr

4th Qtr

Person 2 – Steve

Semi-retired Monthly fixed retirement payment Does tree-work to supplement fixed income Tree work comes in sporadically throughout

the year. Earning Per Share (EPS) = $1

Steve’s EPS

0

0.05

0.1

0.15

0.2

0.25

0.3

0.35

0.4

2001 2002 2003 2004

1st Qtr

2nd Qtr

3rd Qtr

4th Qtr

Person 3 – Jim

Self-employed Photographer Work is very seasonal A few steady client Income comes in spurts depending on the

season Earning Per Share (EPS) = $1

Jim’s EPS

0

0.05

0.1

0.15

0.2

0.25

0.3

0.35

0.4

2001 2002 2003 2004

1st Qtr

2nd Qtr

3rd Qtr

4th Qtr

Person 4 – Frank

Has a new idea that he may be able to sell for a fortune.

Has been building up support for his idea for about five years and feels that this is the year it will take off.

Because his idea has not sold yet, he does not have any earning, and has actually been losing money. EPS = NMF (No Meaningful Figure)

Frank’s EPS

-0.45-0.4

-0.35-0.3

-0.25-0.2

-0.15-0.1

-0.050

2001 2002 2003 2004

1st Qtr

2nd Qtr

3rd Qtr

4th Qtr

Person 5 – Joe

Entrepreneur Involved in several projects including buying

selling houses and renting commercial property

His Earning Per Share for the past year is $0.70.

Joe’s EPS

-0.15

-0.1

-0.05

0

0.05

0.1

0.15

0.2

0.25

2001 2002 2003 2004

1st Qtr

2nd Qtr

3rd Qtr

4th Qtr

How much are you willing to pay for your share?

Shares of stock are sold through an auction on the stock exchanges, much like things are bought and sold on e-Bay.

Any shares you buy require that someone else be willing to sell at your price.

Other buyers are bidding against you based on what they think a share is worth.

How much are you willing to pay for your share?

Why should you pay more for a stock than it earns per share?

Would you pay me a $1 if I agreed to pay you a $1 each year for the rest of your life.

Would you pay me more than a $1 for that steady stream of income?

PE Ratio(Price/Earnings Per Share)

How do you determine what you are willing to pay for a share of stock?

While the market determines the going price, buyers do not always agree on what the right price is.

The price that a stock is selling at divided by its EPS is its PE Ratio.

How much should you pay for a share of our fictitious people?

Lew – EPS $1 Steve – EPS $1 Jim – EPS $1 Frank – EPS NMF Joe – EPS $0.7

Remember that you are buying into their future earnings stream.

How do we determine what their futures will hold?

Past performance may be an indication of future performance.

What is the news about the person.

Evaluating Past Performance

0

0.05

0.1

0.15

0.2

0.25

2001 2002 2003 2004

Lew

1st Qtr

2nd Qtr

3rd Qtr

4th Qtr

0

0.1

0.2

0.3

0.4

2001 2002 2003 2004

Steve

1st Qtr

2nd Qtr

3rd Qtr

4th Qtr

0

0.1

0.2

0.3

0.4

2001 2002 2003 2004

Jim

1st Qtr

2nd Qtr

3rd Qtr

4th Qtr

-0.5

-0.4

-0.3

-0.2

-0.1

0

2001 2002 2003 2004

Frank

1st Qtr

2nd Qtr

3rd Qtr

4th Qtr

Evaluating Past Performance

-0.2

-0.1

0

0.1

0.2

0.3

2001 2002 2003 2004

Joe

1st Qtr

2nd Qtr

3rd Qtr

4th Qtr

Evaluating Past PerformanceLew

0

0.05

0.1

0.15

0.2

0.25

2001 2002 2003 2004

Lew

1st Qtr

2nd Qtr

3rd Qtr

4th Qtr

Steady Income Little to no change over time Very predictable

Evaluating Past PerformanceSteve

Steady Income Little to no change over time Not very predictable

0

0.1

0.2

0.3

0.4

2001 2002 2003 2004

Steve

1st Qtr

2nd Qtr

3rd Qtr

4th Qtr

Evaluating Past PerformanceJim

Steady Income Little to no change over time Each quarter is very different, but year-ago quarters

are very predictable.

0

0.1

0.2

0.3

0.4

2001 2002 2003 2004

Jim

1st Qtr

2nd Qtr

3rd Qtr

4th Qtr

Evaluating Past PerformanceFrank

No Income Lots of change, but no pattern All hope is placed on the promises of the future,

because the past doesn’t show us anything positive.

-0.5

-0.4

-0.3

-0.2

-0.1

0

2001 2002 2003 2004

Frank

1st Qtr

2nd Qtr

3rd Qtr

4th Qtr

Evaluating Past PerformanceJoe

EPS less than first three options ($0.70) Lots of change. Recent past is better than more distant past. What might EPS be next year?

-0.2

-0.1

0

0.1

0.2

0.3

2001 2002 2003 2004

Joe

1st Qtr

2nd Qtr

3rd Qtr

4th Qtr

Evaluating Future Performance

Cannot know the future Based on what is planned for the future and

your best guess on what might actually happen

Very limited information News, Rumors, Gut Feeling

Evaluating Future PerformanceScenarios

Rumor has it that Lew’s Roth IRA’s investments are about to go through the roof.

Steve has issued a statement that his book is almost complete and he has a publisher.

Steve hires Micah to do more work.

0

0.05

0.1

0.15

0.2

0.25

2001 2002 2003 2004

Lew

1st Qtr

2nd Qtr

3rd Qtr

4th Qtr

0

0.1

0.2

0.3

0.4

2001 2002 2003 2004

Steve

1st Qtr

2nd Qtr

3rd Qtr

4th Qtr

Evaluating Future PerformanceScenarios

Jim was overheard at the ball fields saying that he was tired of dealing with coaches.

Frank has just taken out a home-equity loan on his own home to pay for marketing of his product.

0

0.1

0.2

0.3

0.4

2001 2002 2003 2004

Jim

1st Qtr

2nd Qtr

3rd Qtr

4th Qtr

-0.5

-0.4

-0.3

-0.2

-0.1

0

2001 2002 2003 2004

Frank

1st Qtr

2nd Qtr

3rd Qtr

4th Qtr

Evaluating Future PerformanceScenarios

Interest rates are rising. The news has a

headline about the “real-estate bubble”.

Joe bid on a big piece of property, but did not get it.

-0.2

-0.1

0

0.1

0.2

0.3

2001 2002 2003 2004

Joe

1st Qtr

2nd Qtr

3rd Qtr

4th Qtr

Projecting Future Growth

I would be willing to pay more for a company this year if I felt that my yearly payment would go up each year.

Because of this, just comparing PE ratios may not make sense.

As a company’s earning grow, so does the value of my investment.

Projecting Future Growth

• By dividing the PE Ratio by the Growth Rate, I have a way of comparing companies with different growth prospects. (PEG Ratio)

• A PEG Ratio of between 1 and 2 is generally considered good.

• A PEG Ratio of less than 1 leaves you wondering why no one wants the stock

• A PEG Ratio of more than 2 may mean that the stock is selling for too much.