Good Evening Budding Traders!

We are back to set the foundation for successful trading. During our last meeting, we started to break down the concept of fundamental analysis. This concept being, that we are able to use numbers to discern the value of company A versus company B. Also, we use these same numbers to try and peek into the future of any particular company to figure out if they are worth buying and what might be a fair price. The knowledge of fundamentals is part of our transformation into a well-versed trader. As we pointed out last week, we will sometimes need to dive very deep into fundamental analysis and other times we will just need to have a tertiary knowledge depending on trading style and timeframe.

We looked at three popular metrics last week that traders and investors alike use to determine value. Those three metrics are the P/E ratios, the PEG ratios and the Debt to Equity ratios. Did you have a chance to review your holdings to see how those metrics compared to other companies in that particular industry? Were you able to discern whether your portfolio is fundamentally sound? We discussed these metrics in some detail last week and I mentioned that I have a few other fundamentals that I watch very closely and that myself and my peers use to determine whether a company is a good long-term value or whether the company simply doesn’t warrant holding onto for the future. The next three metrics we are going to examine are free cash flow, price to book ratio, and payout ratio. Let’s look into each one of these and see how they measure value for our companies.

Free Cash Flow

First up, is free cash flow. Free cash flow for a company is the cash available after all the capital expenditures are accounted for. A better way to say this is this is the money left over after all the expenses for running or building the business has been dealt with. This is a big deal and it is easy to understand why this is a big deal by relating it to your own household. Think about a typical family household, there are paychecks that come in and then the bills are paid and typically what’s leftover is the households free cash flow. Sometimes this is a lot of cash for those who live within their means and for those who live outside their means it can sometimes be a negative number. Anyone who has a negative free cash flow number is on borrowed time and is usually in trouble going forward as that household is borrowing to meet its needs and that can only work for so long before assets need to be liquidated or worse yet, bankruptcy sets in. This is no different for a company if they are making enough money to cover the costs of running the business and they have cash left over then it is a sign of financial strength. The more cash the better the company looks and the more issues they can deal with without adverse effects. To give you an example of good free cash flow versus not so good cash flow, look at IBM versus QCOM. IBM sits on approximately 9 billion in free cash flow and QCOM is about half of that. These two companies are in the same sector but are not exactly the same business but I think you can understand, he who has the most cash wins and this usually holds true for businesses.

P/B Ratio (Price-to-Book Ratio)

Next up is the P/B ratio, or price to book ratio. The price to book value measures the current stock price versus the book value. The book value relates to the companies total asset value. This essentially tells an investor how much they are paying for the assets of the company. This ratio can be valuable to a point. Obviously, a company with a lot of assets can be a good thing. Having many assets means you have spent some capital acquiring assets and this is a positive to the business and the investor in the realm that if the company got into trouble it could liquidate some assets and take care of debt obligations. The trouble with just looking at this ratio is we are not counting in the current levels of debt so this is also we need to watch and take into consideration when determining value.

Payout Ratio

Thirdly, we look at the payout ratio. The payout ratio is the percentage of earnings that are paid out as dividends. This metric can be useful in determining whether the company is doing well enough to sustain its current dividend output and possibly increase it in the future. Why would we care about the dividend? The dividend can tell us all we really need to know about a company to determine its value and we will discuss more on the dividend and its role in the fundamental analysis in next week’s chapter.

In addition to the dividend discussion next week, we are going to go over the intangibles that can make a company worth owning, things like goodwill and brand recognition just to name a few. We will also wrap up our fundamental discussion by bringing all of these things together into an actionable series of steps to determine the overall health of a company we may be looking at. In our wrap up we are going to discuss the pitfalls of fundamental analysis as well, that way we will be knowledgeable just like professional traders and investors and we will be on our way to transforming into the person we want to be.

Until next time, stay fundamentally sound my friends!

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