Tuesday Trading Tutorial - January 20, 2009

Following the previous week’s article pertaining to the analysis of the markets as a whole. This week’s write-up with delve into more specific aspects of researching and potentially trading a stock, once more in-depth profiling of a company is achieved.

Known as fundamental analysis, this is a method of valuating a security or stock, which consists of the examination of a company's financial standing along with their overall operations. This practice would include the analysis of sales, earnings, growth potential, assets, debt, management, products, and competition.

Fundamental analysis takes into consideration only those variables that are directly related to the company itself, rather than the overall state of the market. Its main purpose is to determine a company’s fair value along with the quantitative forecast of a company’s potential for future price movements.

To obtain these figures, one researching a stock would most often look at a company’s balance sheet, income statement, and statement of cash flow, along with quarterly earnings reports and annual reports.

Comprehending the general dynamics of fundamental analysis and its importance to options trading is paramount, along with being a collective experience. Implementing the data and information once researched into a trade takes time and effort in order to keep up with a company’s performance on a daily, weekly and yearly basis.

It has been said that in order for an investor to succeed at trading, one should take at least one hour per day per stock to do their homework and analyze a company. This is solely beneficial when it comes to placing a trade that has limited risk, but performs adequately to insure the investor of a potential profit. It is always potential in that nothing in this environment is ever guaranteed and without risk.

Many factors go into researching a company before placing your hard-earned money into a trade. There are variables such as an influx in a company’s sales due to a new product release, or a change in leadership that influence a company’s stock to trade sporadically. In addition, there could be instances of a natural disaster, which could trigger a selling action of shares, along with ongoing litigation for a company that may influence its trading habits. An investor needs to take all of these circumstances into account when looking for a company to invest or trade-in.

As one becomes more and more inclined to analyze the given information pertaining to potential trades, it becomes necessary to be able to distinguish between pertinent data and just noise. Some of this knowledge will be obtained through trial and error, while most of it may come to you as instinct. As one progresses as a seasoned trader, you will be able to more effectively gauge the importance of incoming news and data to evaluate a company’s performance or future earnings potential.

Some of the important aspects of a company’s business model to examine in regards to performance and future earnings are the company’s Earnings per Share (EPS), Earnings Growth, Price-to-Earnings (P/E) ratio and Price-to-Sales (P/S) ratio.

Leading off, a company’s EPS is most effectively used to gauge a firm’s overall financial strength. It is here that a company’s past and future earnings are calculated by a company’s net earnings by the total number of shares outstanding. The resulting number is thus compared to the previous number corresponding to the same quarter from the previous year. If the number is larger than the previous year, than most likely the company’s stock is on the rise, or soon to be. However, if that number is below the previous posting, than the company’s financial status could be in jeopardy, which could in turn, send investors elsewhere.

The key to analyzing a company’s EPS shares for future earnings, is to look for companies that have higher projected EPS expectations that the previous years’. When looking at a company’s EPS, you can conclude whether the company has been profitable over the past year, remained unchanged or fallen in productivity.

As for earnings growth, here, much like EPS, an investor looks here to analyze a company’s growth over the past quarter in order to access a company’s profitability. In relation to the previously stated EPS and earnings growth, one of the most analyzed portions of a company’s performance comes from their P/E ratio.

The Price-to-Earnings ratio compares the company’s stock price to the company’s earnings per share. It is used to describe the current state of a stock’s price and is not used to forecast any future price movements of that stock. The main function of a P/E ratio is to tell an investor how many times a stock is trading above earnings. To calculate the current P/E ratio, divide the current stock price by yearly earnings per share.

A general rule of thumb states that a faster growing company will have well-above industry average P/E ratios that may lead to higher earnings in the future. However, this rule is just a generalization, not an absolute. Putting all your faith and capital, for that matter, into a company that has high P/E ratios could lead to massive losses as any input from the outside world could lead to a stock’s demise.

The final aspect of analyzing a stock is the Price-to-Sales ratio, which is solely used to gauge when a stock is overvalued or undervalued. In order to calculate this ratio, simply divide the price of the stock by the company’s sales per share. One other factor not mentioned above was the company Quick Ratio, which also shows a company’s weakness or strength. It is calculated by dividing a company’s current assets by their current liabilities. If it is a positive number that company shows strength, and if it is over 1, then that would show that for every Dollar spent, that company is bringing in more than a Dollar in earnings.

With all said and done, fundamental analysis is just a small step involved in the overall scheme of options trading and investing. Keep in mind that there is no one particular piece of data that will show you exactly what is going on within that particular company.

As a less-seasoned investor, you should always start off with two or three stocks that you have substantial knowledge about in various industries in order to gauge exactly how those sectors trade over time. A key to stock analysis is to not be too bogged down with so many financial figures that may cloud your judgment as to the performance of a stock.

From there, the keys to improving your analytical skill will solely rely on your patience, your determination and your collective experience over time. Happy trading and the best of luck to you in your future endeavors.

Check back periodically as we will continue to look further into options trading and what makes up an investors character in their choices of particular stocks.


For more information on the stock and options markets check out the wealth of information at BetterTrades.