One of my favorite quotes – both in life as well as in trading – reads, “A good plan is like a roadmap; it shows the final destination and usually the way to get there” – H. Stanley Judd. The creation of the roadmap is critical to success in investing and trading. It all begins with formulating a price expectation for an underlying equity going forward. The stock market is an anticipating instrument. The share price we pay today reflects the anticipation of how well the company will perform in the future. How do we create this longer term expectation? The answer begins with fundamental analysis.
Fundamental analysis is useful in helping determine the value of a stock by analyzing data that is fundamental to that particular company. There are literally dozens of different metrics that can be considered in this exercise. Perhaps the most important of these is earnings. Very simply, earnings is how much profit (or loss) the company had after accounting for all expenses. As investors, we take this metric one step further in looking at earnings-per-share (EPS) – taking the company’s net earnings and dividing this by the number of outstanding shares. EPS can be looked at for the past (trailing EPS), the current time frame (current EPS) or forward looking based on expectation (forward EPS).
Remember that “forward looking” nature of the markets? Taking our analysis one step further leads us to the P/E ratio. You calculate this metric by taking the price per share and dividing by the EPS. This is commonly referred to as the multiple. You can look at this metric in past, present or future time frames. How much are investors willing to pay for past/present/future earnings for the company? The P/E ratio answers that question. How can you determine if the multiple is reasonable? One way is to look at the history of the company’s P/E ratio across time to compare the current figure to past data. Occasionally, the market undervalues the future prospect of earnings in a company’s current share price. One way to determine if this might be the situation is to look at the PEG ratio.
The PEG ratio takes the multiple and divides it by the expected percentage earnings growth for the next year. Let’s say a stock has a P/E ratio of 40 and is expected to grow its earnings by 20% in the next twelve months. This gives this equity a PEG of 2. In general, the lower the PEG, the better potential bargain you may have in the shares as investors are paying less for each unit of growth. Caution must be exercised here as to determine if the market is “wrong” in a low PEG or if they see “stormy waters ahead” causing the PEG to be at the lower valuation.
If you are just getting started on your trading and investing business, how can you begin to develop a watchlist of equities that you wish to research and ultimately trade? You don’t have to trade hundreds of equities to be successful in this business. In fact, becoming somewhat of a “specialist” in a handful of equities is not only easier but often more profitable as an enterprise. Start with what you know. What do you love to do either professionally or for fun? What things are you really good at? What do you do to earn money? Where do you spend your money? Answers to these basic questions can be a good starting point for developing your watchlist. As you begin to watch and trade this list over and over across time, keeping up with the fundamental data becomes not only manageable but “second nature” to a degree.
At OptionsANIMAL, we combine this fundamental research with technical and sentimental analysis to help form that forward-looking expectation that is the starting point of each trade. We look at the fundamentals mentioned above as well as others that are quite relevant to options trading. One of the great advantages to buying and selling options is that we can formulate trades for many different expectations. We can search out companies with weak fundamentals to trade from a bearish standpoint. We can look for bullish opportunities in companies who are excelling fundamentally. We can take our longer term expectation from fundamental analysis and combine it with our knowledge of technical analysis to put together trades for shorter duration time frames. We can even profit from rather quiet/stagnant price action in our equities.
My expectation? Continued profits from knowledge. Thank you OptionsANIMAL.