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More and more people are using Integrated Investor and incorporating fundamentals into their trading. This is a fantastic advancement and returns the edge back in favour of those students wishing to make informed trading decisions. For those who will be attending (or are thinking of attending) the exclusive MasterKey course, there will be a whole section on how to use fundamentals in integrated analysis, however, here’s a little primer on one of the great fundamental analysis ratios; the P/E.
Ratio analysis isn't just about comparing different figures from the income statement, balance sheet and cash flow statement. It's more about comparing the figures against previous years, other companies, the industry, or even the economy in general. Ratios look at the relationships between individual values and relate them to how a company has performed in the past, and might perform in the future. By looking at a company’s sales divided by its market capital, you get an immediate idea of how much an investor is willing to pay for every dollar of sales made, for example. Although you will cover many of these ratios (and more) in the Masterkey, I want to start in familiar territory, the well known and much loved P/E ratio.
Several ratios are easy to calculate and easy to use when it comes to the quick decision making and analysis of a trader. The P/E ratio is probably the best known and most easily acquired ratio. Sometimes called the multiple, the P/E is often thought of as a bit of a dirty ratio and is open to some differences in interpretation, but for a ‘quick glance’ it provides some instant information. To calculate the P/E ratio is simple enough:
| P/E = |
Share Price
EPS
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Where
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| EPS = |
Earnings per Share |
The idea behind the P/E ratio is that it is a prediction, or to use a better phrase, an expectation of the company’s performance in the future. A higher P/E would suggest that market participants are expecting big things from a share, compared to one with a lower P/E. A quick check of the average P/E of the overall market and comparison to the P/E of your share, will also reveal a bit more; if the P/E is much greater than the average, the bulls have a vested interest and are looking to see a ramp up in the price.
In the example below it’s pretty obvious to see that Microsoft (MSFT:NASD) has an increasing interim Price/ Earnings history. The blue histogram is clearly increasing in size over the time the most recent quarters. One of two things should happen to return to averages. MSFT will fall in price OR increase its earnings.
click to enlarge
For the integrated analyst, the next step is to check other variables to see what the likely consequence of this increasing P/E ratio is. If there are technical reasons to suggest a fall in price, or the options market is axed for a drop, a trading plan can be implemented on the short side.
Of course, nothing is fool proof and that’s why we look for confirmation from other trusted sources. The limitations of the P/E ratio, for example, may arise from accounting procedures. Earnings (for the EPS component) may be either forecast or previously reported figures making comparisons difficult. You can get around this by doing a little extra work and reading the fine print on company reports. Within the ValueGain component of IntegratedInvestor, all the figures are actual reported earnings relative to price on that quarter end so the company comparison tool is consistent.
Stay Sharp,
John Jeffery
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