Hola Goal-Setters!
I trust you all have your goals written down and reviewed. I also trust that you have done the work to imprint those goals into your subconscious. If you have done this then you are well on your way to success. In the first few episodes of this Rookie Corner journey, we discovered the hidden tool of goal setting. We used this tool to give us the vision to build ourselves a path to a successful transformation into a successful trader. This transformation begins now!
To transform ourselves into the person we want to be, we need to model ourselves after those who are already successful at what it is that we want to do. So we talked about what successful traders are and what they do to be successful. The first thing we talked about is how successful traders had a very clear understanding of their business, they are very knowledgeable. This is where we will start, we will learn the things that successful traders know and then we will be that much closer to transforming into one and the same.
Fundamental Analysis
First up is fundamental analysis. This is one of four pillars that we need to learn to ensure that our trading foundation is rock solid. Essentially, Fundamental Analysis is a system of comparing the valuation of one company versus another. There are a million different metrics we could use to compare companies but we are going to focus on a chosen few that have served me and my peers well in their investing and trading lives. We must remember we need a thorough understanding of the business we are in but that doesn’t mean we need to know every detail of every aspect of the business. This would be next to impossible to do all of that well. So instead we seek to understand all the aspects and then become proficient in the aspects that serve us well. The rest we let our team of experts take care of. Didn’t know you needed a team to trade? To be successful you do. We will delve into that in another part of this journey, for now just understand that you are going to run your trading like a business because that what it is and all successful businesses have teams.
Ok, before we do a deep dive into the fundamental analysis we need to discuss what type of trading or investing we are actually doing as it makes a difference to how much weight we give to fundamental analysis. Let me explain this by saying that if you are day trading, then the fundamentals of a company are probably less important than if you are choosing a retirement portfolio that you plan on passing down to your children. This only stands to reason, right? We must remember that we always need to be aware of the fundamentals of a company but that in the latter case above that we need to drill down the overall health of a company and be very certain that it can withstand the test of time.
Now is the time for our accountant friends to shine. We need to look at the balance sheet and income statements of a company to get the real story behind how well a company is doing or how healthy they are now and have been in the past. We are going to break this research into two components. First, we are going to go over a couple of popular metrics that some folks use to determine the value of a company and then in the next installment of the Rookie Corner we will go over some metrics that are not as widely known but that can be very good tools for rating a company’s fundamental value.
The most popular metrics for determining value are P/E ratios, PEG ratios, and Debt to Equity ratios.
P/E Ratio
First the P/E ratio, or the price to earnings ratio. This number tells an investor how much they have to pay in stock price for one dollar of earnings. Let’s use an example to illustrate this point. Currently, APPL has a P/E ratio of approximately 18/1. So what does that mean? Is it good, bad or indifferent? We need to compare this with other companies similar in nature to determine whether this number is good, bad or otherwise. So let’s compare HPQ. Although not a direct comparison to AAPL, HPQ does compete in parts of AAPL’s business. HPQ has a P/E of approximately 10/1. So does this mean that you go out and buy HPQ? No, there are other factors to consider.
PEG Ratio
Next up is the PEG ratio. This is similar to the P/E ratio except that it takes growth into account and it still needs to be compared to have any use. With the growth component taken into consideration, some investors use this to forecast what a company may do in the future from an earnings standpoint. Earnings growth is a projection from past numbers and this can be problematic in some cases. We will deal with the pros and cons of all these numbers when we rap up the Fundamental Analysis section. The takeaway from this ratio is that it can be used to possibly find undervalued companies that have some growth potential and that could reap bigger rewards down the road.
Debt-to-Equity Ratio
Lastly, we have the Debt to Equity ratio. This ratio gives us a look at how much debt a company is carrying in comparison to the equity in the company. This is a very important metric for a multitude of reason but the most important reason is that bad debt can swallow a company if it is not kept in check. Some companies are really good at using OPM (other people’s money) to make profits but others can misuse debt and this can be a precursor to bigger problems.
So you have been introduced to three metrics that we can use to determine the health of a company. Next week we will go into what I feel is the most important fundamental analysis aspects and we will tie this all together so that we can see how we can use this knowledge to our benefit. In closing, I want to reiterate that we always need to be aware of the Fundamentals and in some instances, we will use them more or less depending on the trading timeframe we are using.
For homework, take a look at the above metrics for some of the companies you would like to own long-term and see how healthy the companies are in regards to other companies in the same industry. Doing the homework will help you on the second part of your transformation. The second part of successful trading is practice and by doing the homework you are practicing and sharpening your fundamental analysis skills.
Adios!
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