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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I feel incredibly lucky to have come through today completely unscathed.  In an effort to document a potentially over-emotional day, I offer the below commentary. Let’s hope I can be so ebullient tomorrow.

I am up half a percent today despite a 75% cash position or perhaps because of it. Luck was certainly on my side today as my longs held up well.

After missing most of yeterday’s parabolic move, today I was rather relieved that the majority of my cash was tied up in a broker move. I had added $AMD yesterday morning based on a very bullish and liquid chart as well as an upgrade from Citi. I joined Chess and the gang in 12631 in $BZ & $BEXP as well. $AMD performed strongly today while $BZ stayed fairly flat.

$BEXP was a roller coaster ride. Fortunately, I hedged the oil play with $SCO this morning which was also a win for me. If you read my “not” oil post in the Peanut Gallery last week, you would know that I believe in the volatility of oil at the moment and recognize that it can go either way in January, so I was ready to be nimble and move with it in either direction. Many in 12631 sold $BEXP when it broke down, but I remained calm during it’s bottom partially because I was out running errands but I still check my positions regularly and saw it’s demize (sic). I could have sold it then, but I chose to wait it out. I was glad I did.  Recognizing, however, that it was no longer a high probability trade, as Chess confirmed, I sold it flat at the end of the day.

I added $CBAK & $CHOP this morning…happily as it turns out. My bank stocks & $MIPS pulled back today, but not enough to cry disaster.

I was also immensely happy to see such strength in $PWER.  This is my stubborn old man trade as many of you know. It seems to like this range now, which is good news for the stock because of its high volatility. This tells me that investors are getting comfortable with this price which means it now has a chance to go higher on better reports through the coming quarter.

My first fundamental post is almost ready. I must admit that I thought I would find it much easier to write a simplification of basic stock valuation. I pray that I don’t screw it up. Stay tuned.

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Many of you read my post entitled “Jack be Nimble” in the Peanut Gallery. At first the post seemed to be about analyzing the price of oil until I eventually stated that my point was to wait for price action. Some of you teased me for churning up the very noise I suggested that we ignore, but I feel there is a place for that noise. Some of you prefer to make only short term trades based on price action alone and feel overwhelmed by large amounts of data and I respect that completely.

Personally, I enjoy looking at both styles of stock trading in order to get a bigger picture. I have a value investor/fundamentals background and in one of my other posts I also mentioned that what I had noticed was that even if my analysis for valuation for a stock was correct, I still didn’t feel I had a strong sense of where to get in or out of a stock; I would guess at a bottom, worse I would often sit on a stock and ride it down into a grotto of losses waiting for it to return because I was sure I had the value right.

Once I started getting the idea for getting on and riding a trend-line and looking for triangles, my trades became more efficient, but I was still strictly value investing, which has it’s limitations.
When I decided to add in shorter term trades based solely on technicals, my ability to bank coin grew exponentially. And so my current style is to do a combination of both. I use technical charting to know when to get in and out of a position and I use valuations to decide how long I am willing to stay in a position. This is not to say that I value every stock I get into to. There is no point in spending extra time to value a stock that I am in just for a breakout.  I won’t stay in a stock for very long unless I am comfortable with the valuation. I do find that I will be more cautious about a stock whose value I am concerned about, but is presenting a bullish chart. If I get in, I do so with a short leash.

As I am now using Worden StockFinder to screen for bullish patterns and have learned to train my eye to spot the patterns, I have become pretty good at stock picking. In addition I have learned to look for buying volume to let me know when it is time to pile in. I am currently studying the candlestick patterns in order to take my technical analysis to the next level, but I digress as I have learned much of this from chessNwine and Ragin Cajun and must give absolute props to the amazing trading room and educational tools that have been developed in 12631 by Fly, Chess, RC, and Jeremy.

For this reason, I will focus my posts here on sharing with you the decisions I make when I make them, but I will also do a series of posts I will call, “Fundamentals for Dumb-Me”. While we have excellent value investors who post and blog on Ibankcoin, they tend to give their analysis rather than teach valuation skills.

There were some excellent posts last year by @robert that discussed stock valuation, but these were fairly complicated. I must give full props to @robert for his pieces are truly educational and exceptionally well written if not a bit advanced for our purposes. If you wish to take the time to read his posts and do the homework that would be required to fully understand them, you would acquire a good buy-side view of fundamentals. By no means will I suggest that you will be able to do full fundamental analysis from my simplified versions, as there are too many pieces to the puzzle but I hope to give you some ideas on how to look at the bigger picture. Basically I intend to take some portions of what @robert taught us last year and simplify it.

My first post in this series will include a glossary of terms as it will not behoove you to have to look up each set of initials while trying to understand their context. Certainly there are plenty of sites on the internet where you can find these, buy my goal is to put it all here for you in one place.
Please feel free to ask for any specifics as we go along. Happy trading and learning.

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First of all I would like to thank you, my readership, for reading, and commenting on my posts and ultimately voting me into the position of King of the Peanut Gallery. It has been a great pleasure sharing what I have learned and truly rewarding to hear from so many of you that you are finding my ideas of some value.

I look forward to sharing my work with you over the next month.  I find that my own knowledge and trading improves when I articulate it and answer your questions. This is a great exercise in focus for me, so I will enjoy learning with and from all of you.

My portfolio consists of two parts, my long term port and my short term port. While my long term port tends to remain invested, my short term port has a varying cash position. As of yesterday, my short term port is now 75% cash. I went to a large cash position for two reasons (other than taking profits). One is the uncertainty of the market action for the start of 2011. Those of you who know me, know that I am bullish with regards to 2011, but I recognize that we can easily see a correction and I prefer to wait for the price action before deciding how to allocate that cash, but I have another reason as well. I am moving cash to a new broker, separating my long term holds from my short term holds by brokerage.

As this will take a few days, my trading will be limited for the first week of January, but don’t worry, I still have lots of ideas and set-ups that I will share with you when the time comes.

Meanwhile, I will let you know that my current holdings consist of the following.

In my long term port : $VZ, $FTR, $NZT (yes I know there is a theme), $WWE & $PWER.

Stocks that I am watching for entry to add to my long term port for 2011 include $GNK and $MU.

In my short term port, I make a combination of day and swing trades. These can last to anywhere from a few minutes to a few months. I tend to allocate very small positions initially so that I can be nimble and liquid at all times.  My short term port includes : $TRLG, $F, $MIPS, $RF, $HAFC, $ITUB, $NARA. Again you will notice a theme in small banks coming into 2011, but certainly this is not the first place you have heard this. Many of us took The Fly’s directive to heart when he suggested we look at small banks; I still like the set-ups in these and I will be watching the price action closely in the coming days.

I will leave it there for now. I am excited about the coming month and a lucrative 2011.

And a very Happy New Year to all !

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