Fundamental analysis is that mysterious component of investing that is cloaked in obscure financial terms such as PEG ratio, Levered free cash flow and EBIDTA. While some ignore the fundamentals entirely in favor of rigorous technical analysis and some focus exclusively on sentimental analysis, Phil and I tend to focus heavily on fundamental analysis as the foundation of our investing philosophy.
This might appear impossible to discern if you look at the numerous trades mentioned regularly. Option strategies such as bull call, iron condors, collars and calendars are so prevalent that it would be easy to solely classify our methodologies as those of option strategists. This may even be true over the short-term if we play an event such as an earnings announcement. But our primary focus is long-term and rooted behind a long-term approach is a solid understanding of fundamental analysis. So, with that said, let’s take a look at a couple of investing terms that might prove helpful when conducting fundamental analysis.
P/E Ratio [Price per share/Earnings per share]: In Nov 2000, Researching Motion(RIMM) traded with a P/E > 1000. Usually we see numbers such as P/E of 10, 25, 30 etc. For example, a stock trading at $30 per share with earnings per share of $3 has a P/E of 10. You can think about it as an amount that investors are willing to pay for a $1 of earnings. For example, investors in 2000 were willing to pay $1000 for $1 of RIMM earnings!
Let’s take a straight-forward example of starting a simple business – a lemonade stand. You set up a stall and start selling lemonade and make $1 profit at the end of the day. What is it worth to somebody to buy your lemonade stand? Well if they believe you will consistently earn $1 in profits each day then they know that by the end of the week the business will have earned $5, so perhaps they deem your business to be worthy of trading at a 5X multiple of earnings, $5.
Baidu and VMware trade today at a P/E > 200 while Intuitive Surgical trades at a P/E > 100. Another way of viewing this is that investors are willing to pay over $200 for each $1 of earnings produced by Baidu and VMware while they are willing to pay over $100 for each $1 of earnings produced by Intuitive Surgical.
If we take Baidu as an example, this means that if Baidu’s earnings remained the same going forward it would take over 200 years for an investor to receive his/her original capital back! At which point inflation will likely have eroded a huge portion of it!
If investors looked solely to earnings they might invest in YRC Worldwide that has a P/E of approximately 7. So what else do they look for?
Growth!
Wouldn’t it be nice to have a figure that puts an explicit value on the expected growth in earnings of a company? That way we could determine whether the P/E multiple was high or low relative to the earnings growth rate.
Well we do! That figure is the PEG which is simply [(Price/Annual Earnings)/% Annual Growth].
The PEG ratio measures the tradeoff between what investors are willing to pay for earnings and growth. If a company is growing at 20% per year then a P/E of 20 might be reasonable. In fact, this would correspond to a PEG of 1.0, which is commonly considered to infer a company is reasonably valued. However, PEG numbers that exceed 2 usually imply that a company is approaching overvalued levels.
PEG is not a perfect indicator. For example if fails to correct for inflation. In addition, growth rate estimates are always subject to change due to execution setbacks, economic impact and so forth.
So what are the PEG ratios for the companies mentioned above?
Baidu PEG = 2.85
ISRG PEG = 2.36
VMware PEG = 3.96
According to the standard “rule of thumb” that PEG figures greater than 2.0 imply companies are somewhat overvalued, all 3 companies currently fall into that category. One fundamental metric is rarely a reason to make an investment decision either way but it can surely open our eyes to the premium we may be paying and at the very least force us to question whether we are still comfortable with our investment.
Wishing you a wonderful week ahead!
OptionSage
