Fundamentals for Dumb-Me: the very basics (part 1)

Before I start, I will point out that everyone has their own method and viewpoint for valuation.  The below is how I see it and while some pros may argue with me for my simplicity, strangely,  we always seem to arrive at the same place in the end.

That said, I have not decided if I will continue down this path. Most of you will either be way beyond this level or have no interest. I will wait to see if there is enough interest before I decide to continue.

You will get used to my old musical references eventually.

A reference to the song Do-Re-Mi from The Sound of Music:

Let’s start at the very beginning
A very good place to start
When you read you begin with
A-B-C
When you value you begin with
EPS
…or Earnings Per Share – in other words, a company’s net income divided by the number of shares outstanding. This is one important piece of information you will need to adequately value a company’s stock. You will also hear the term, Diluted EPS, which will take into account any convertibles or warrants outstanding. These are not included in the outstanding basic share count until converted or exercised whereupon they increase the basic share count and “dilute” earnings. You will find this information in the company’s most recent earnings reports.

Next we will use the EPS to determine the company’s multiple or P/E ratio; that is Price to Earnings or the stock price divided by EPS. This gives us an idea of what folks are willing to pay for a stock in relation to the company’s earnings. If a stock’s current share price is $20 and it’s EPS is $2, the company has a multiple or P/E of 10; that is 20/2=10.

Once you have these two pieces of the puzzle, you will want to check out the company’s most recent earnings report to predict future EPS, or EPS calculated on the next four quarters worth of earnings, and thus forward P/E based on the company’s guidance. This will give you an idea of the company’s expected growth rate. If the company guides earnings of $3 next year, this gives you a growth rate of 50% or a future stock price of $30. But let’s slow down for a moment and go back to our current price of $20 and divide that by our new EPS of $3. This gives us our forward P/E. 20/3=6.67. I mention this because when looking at the key statistics of a stock on Yahoo Finance or Zacks.com, one of the first things I like to look at is forward P/E vs. trailing P/E. If the forward P/E is lower than the trailing P/E, it’s a good bet that the stock is undervalued at it’s current price.

Be careful not to try to predict these too far out. More than a year is too much as any number of unpredictable catalysts can wreck your analysis. Your best bet is to update your numbers each quarter as the company releases earnings.

If you don’t already have a handle on this but would like to, I recommend a little homework. Choose a few stocks that you are watching and figure out the EPS, P/E and forward P/E. Go to the company’s website for a given stock and pull up the press release for the most recent earnings report. You will probably find it under Investor Relations (IR). Everything you will need to do this work is right there. Once you have done this with a few companies, you will not only have a better understanding of it, but you won’t feel like I am speaking a foreign language should we continue down this path in future posts.

I will try not to complicate matters too much as I bring in some other factors that can hinder our basic evaluation.

And as promised, following is a glossary of terms. Many of them we will not use, but it helps to know what they are when you hear them thrown about by the media.  I may update it as we go in case I use a term that I forgot to include.

EPS – Earnings per share

P/E –   Price to Earnings : stock price divided by the earnings per share. Also referred to as the multiple.

P/S – Price to Sales – Stock price divided by the sales per share

P/B – Price to Book – Stock price divided by the value of the company equity, or assets minus liabilities.

DCF – Discounted Cash Flow – Valuing a stock based on a company’s future cash flows.

Cash Flow is the movement of cash into or out of a business.

GM% – gross margin – gross profit divided by revenue or sales

EV – Enterprise Value – Market cap plus total debt minus total cash. The main purpose of which is to define the value of a company if someone were to purchase it. When a company buys another they inherit that company’s debt or cash. The debt lowers the value, and any cash on hand acts like an instant rebate.

EBITDA – Earnings before interest, taxes, depreciation and amortisation. The point is to isolate operational earnings, but folks have all sorts of ideas as to why they want to look at this value. Taxes and interest are not absolute so this allows looking at valuation without them. Depreciation and amortization are “non-cash charges” that some think mask the representation of cash flow on the income statement.

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