The second investor tries to guess how the market may behave based on the psychology of people in the market and other market factors. This type is known as a technical investor, or "Quant." For them the market is like an auction, where the price of a stock soars as eager buyers bid it up – often in ways quite unrelated to its real value. They take higher risks with higher potential returns (and losses).

We will deal with both types and the kinds of tools each uses to reduce their risks and to increase returns. In fact, most successful investors use tools out of both camps for this purpose. We will begin with the first, the Fundamentalist.

To find the intrinsic value of a stock, many factors must be considered. When the price of the stock reflects its value, it will have reached the goal of an "efficient" market. Again,
 

• Price is set by the stock market.
• Value is determined by analysts who weigh all information known about a company.
• Price and value are not necessarily equal.
• If the efficient market theory were correct, prices would instantly adjust to all available information. However, stock prices move above and below company values for many reasons, not all rational. An example is the irrational influence news has on the market, both national and global.

1. Earnings: Company earnings are the bottom line – they are the profits after taxes & expenses. The stock & bond markets are driven by two powerful forces, earnings and interest rates. The flow of money into these markets is ferociously competitive, moving into bonds when interest rates go up and into stocks when earnings go up. It is a company's earnings, more than anything else, that creates value.
1. Earnings per Share EPS: The amount of reported income, on a per share basis, that the company has available to pay dividends to common stockholders or to reinvest in itself. This can be very powerful to forecast the future of a stock's price by giving a more complete view of the company's condition. Earnings Per Share is probably the most widely used fundamental ratio.
2. Though EPS is more important, the price/earnings (P/E) ratio is another useful measure of whether a stock is fairly priced. If the company’s stock is trading at $60 and its EPS is $6 per share, it has a multiple, or P/E of 10. This means that investors could expect a 10% cash flow return:

$6/$60 = 1/10 = 1/(PE) = 0.10 = 10%

If it’s making $3 per share, it has a multiple of 20 (20 times $3 equals $60). In this case, what we’re saying as investors is that we will accept a 5% cash flow return;


$3/$60 = 1/20 = 1/(P/E) = 0.05 = 5%  
3. Certain industries have different P/E’s. Banks have low P/E’s – say, in the 5 to 12 range. High tech companies have higher P/E’s – say, around 15 to 30.
4. If your bank P/E is at 9 and the average is 8, you are paying a premium for the stock. It’s okay if you expect higher earnings. If your retail sector P/E is 16 and the company you’re considering has a P/E of 12, then you’re getting it at a discount.
5. A low P/E is not a pure indication of value. You must consider its price volatility, its range, its direction, and any news that is worthy.
6. The Beardstown Ladies suggest that any P/E under 5 and over 35 is suspect. The market average has been between 5 to 20 historically.
7. Peter Lynch suggests that we should compare the P/E ratio with the company growth rate. If they are about equal, he considers the stock fairly priced. If it is less than the growth rate, it may be a bargain. In general, a P/E ratio that's half the growth rate is very positive, and one that is twice the growth rate very negative.
8. William J. O'Neal, founder of the Investors Business Daily, found in his studies of successful stock moves that a stock's P/E ratio has very little to do with whether a stock should be bought or not. He says the stock's current earnings record and annual earnings increases, however, are indispensable.
9. A key issue: The value as represented by the P/E and/or Earnings per Share are no good to you prior to your stock purchase. You make your money after you buy the stock, not before. Therefore, it is the future that will pay you – in dividends and growth. That means you need to pay as much attention to future earnings estimates as to the historical record. Our Pro-fundity(sm) Page shows the earnings trend, two years actual earnings and two years estimated earnings, for each stock. (when data is unavailable for the two year estimates, Last Quarter figures are shown)
10. Remember Gregory Witt's comment (Rolling Stocks), that rolling stocks are a breed of their own.  Successful rollers do not necessarily have a good earnings record.
 
2. Corporate Debt: This fundamental measure of company health can be found in two ways.
   1. First, the Debt Ratio is calculated by dividing the total debt by total debt plus total equity. This shows the percentage of debt a company has in relationship to shareholder equity. Smaller is better. Under 30% is good, over 50% is horrible.
   2. Another measure is the Debt/Equity Ratio which is the total debt divided by total equity. This is usually shown as a ratio, not a percentage. Again, smaller is better, Debt/Equity ratios of less than 1.0 are desirable.
   3. A company’s debt load can suck the life out of what might otherwise be a successful operation with growing sales and a well marketed product. Earnings are sacrificed to service the debt.
    
3. Equity Returns (ROE): Return on equity is found by dividing net income after taxes by owner's equity.
1. Many analysts consider ROE the single most important financial ratio applying to stockholders and the best measure of a firm's management performance.
2. What is important with this number is whether it has been increasing from year to year.
 
4. Price/Book Value Ratio (aka Market/Book): A ratio comparing the market price to the stock's book value per share. Essentially, the price to book ratio relates what the investors believe a firm is worth to what the firm's accountants say it is worth per accepted accounting principles. A low ratio says the investor's believe the firm's assets have been overvalued on its financial statements. This is another important metric to help us not overpay for the stock.
1. Theoretically, we would like the stock to be trading at the same point as book value. In reality, all stocks trade at a premium (some value above book) or at a discount (when the share price is below book value).
2. Stocks trading at 1.5 to 2 times book value are about as high as we should go, unless solid earnings justify a higher price. What we should be looking for are stocks below book value, at wholesale prices.
3. Companies with low book value are often targets of a takeover.
4. Book value is very important. Look for low book values but keep the data in perspective.
 
5. Beta: A number that compares the volatility of the stock to that of the market. A beta of 1 means that a stock price moves up and down at the same rate as the market as a whole. A beta of 2 means that when the market drops or rises 10%, the stock is likely to move double that, or 20%. A Beta of zero means it doesn't move at all and a negative Beta means it moves in the opposite direction of the market.

 
6. Capitalization: The total value of all a firm's outstanding shares, calculated by multiplying the market price per share times the total number of shares outstanding.

 
7. Institutional Ownership: The percent of a company's outstanding shares owned by institutions, mutual funds, insurance companies, etc., who move in and out of positions in very large blocks. Some institutional ownership can provide stability and contribute to the roll with their buying and selling.  This is an important indicator to us because we can piggy-back on the extensive research done by these institutions before taking it into their portfolios.

And that is why we must do our homework! The Pro-fundity(sm) Page can provide a big boost to help us temper our stock selection by the fundamental analysis already provided on the selected stocks we offer each week.