Investing: Understanding Key Fundamental Indicators

Understanding Key Fundamental Indicators

By Jeff Neal, Optionetics.com
4/3/2006 9:45:00 AM

Typically what makes a stock's value rise is the same thing that makes any price go up: more buyers than sellers. Stocks tend to increase when investors expect company profits to climb. This implies that stock market prices function as a leading indicator and are more useful as a predictor of future performance rather than as a reflection of recent history. In fact, there are a variety of fundamental indicators that can help a savvy investor make a solid stock decision.

The first one is the Price-to-Earning ratio, also known as the P/E ratio. A stock's P/E indicates how popular it is, or, in other words, how much the investors expect its earnings to grow over the coming year. The ratio is calculated by dividing the stock's price by its earnings per share for the past 12 months. The P/E ratio is a key fundamental indicator of how cheap or expensive a stock is because it gauges inflation of price against inflation in earnings.

Typically, investors pay more per dollar of earnings at market tops and less at market bottoms. Historically, a P/E of 18 or higher on the S&P 500 has signaled a high-risk zone for the stock market. By the same token, the blue chips market, which the S&P 500 represents, has traded below a P/E of eight or lower only 10 percent of the time. Thus, a P/E of eight or lower has found the stock market in a low risk zone.

Another major fundamental valuation for the stock market is dividend yields. Most companies pay a certain amount of cash or issue additional stock shares each year to owners of their common stock. The dividend yield equals the cash received per share divided by the share price of the stock. In general, the more expensive a stock becomes, the lowers its dividend yield; the cheaper it becomes, the higher its yield.

It is also important when evaluating stocks to examine the financial averages versus the industry averages. To do this you need to compare your stock's financial figures with its industry. These figures are typically published in a variety of publications, found in most libraries as well as the Internet. These comparisons should include such things as liquidity, profitability and free cash flow.

A good measure of liquidity is the current ratio, which is calculated by dividing current assets by current liabilities. This value only becomes important when compared to the industry averages. A current ratio much higher or lower than industry averages belongs to a firm that isn't run efficiently. If much higher, it means the company has a lot more cash on hand than it needs to function. This fact could make it a potential takeover candidate. If the ratio is much lower, it means the company is in danger of running out of operating funds.
A company's operating margin is probably the best measure of profitability. Unlike earnings, which can be manipulated through accounting gimmicks, the operating margin or profit margin on operations tells all. Companies with strong market positions have higher operating margins than their competitors. And the best firms have operating margins within 10 percent of their all time highs.

Free cash flow should also be analyzed closely, which is earnings plus depreciation less capital spending. Free cash flow should not be negative, even in the worst year a company had in terms in profits. High free cash flow allows a company to expand without seeking outside financing.

By dividing free cash flow by the number of shares outstanding then dividing that number by the price of a stock, you get a free cash flow yield. This represents what the stock would yield if all excess cash were paid out in the form of dividends. The fundamental indicators discussed in this article are very important when determining a stock's value. There are certainly other indicators that are very important as well from the fundamental viewpoint and I will be discussing them in future installments.

Happy Trading.

Jeff Neal
Senior Writer, Options Strategist & Profit Strategies Radio Show Market Correspondent
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