Fundamentals of Research
When you begin investing, you enter a strange new world of language and terms. Each one can help you invest with more confidence and more likelihood of success. Read this chapter and then use it as a resource guide. Come back to it again and again to refresh your memory until the information becomes second nature to you.
4.1 Fundamental Analysis
All public companies need to issue annual reports. While some companies may engage in ‘creative accounting’, the numbers that must be reported can help you see how a company is performing. Is it growing or shrinking sales from year to year? Is it taking on more debt? Is it increasing or decreasing in value? How risky is a company? All this information is can be uncovered as you look at the numbers the company reports.
When you go to any securities market page, you are likely to find a list of abbreviations and numbers. Making sense of these numbers allows you to invest wisely. Once you know about them, it’s easier to choose instruments with a higher probability of rising.
Fundamental Cheat Sheet
|Fundamental||Definition||Investors typically believe the numbers indicate|
|Beta||measures volatility||lower number = lower risk|
|Dividend Ratio||Dividends/earnings||higher number = increased dividend payout|
|Debt Ratio||total debt / total assets||Lower (below 1) stronger company|
|EBITDA||company’s ROI||Lower number = cheaper valuation|
|EV Enterprise Value||Total assets of company||Higher number = larger company|
|EV/EBITDA||Best measure of company value||Lower number = better valuation|
|EPS||Earnings per share||Higher number = more profit|
|PE Ratio||Price to earnings. Quick company assessment.||Lower number = better valuation|
|Market Cap||Size of company||Large number = bigger company|
|Volume||Number of shares traded||Large number = more trading interest|
52 Week Range lets you see how the instrument has traded over the past year. You can compare the current price to the high and low. The chart will show you the trend, either up, down, or sideways. If it’s coming off lows, it may be undervalued.
Beta tells you the volatility of a security. A Beta of 1 is average, so a fraction below that means it is less volatile than the overall market. A higher Beta shows the price fluctuates more than average. A Beta of 1.2 means the security can be 20% more volatile than average. Traders like the increased volatility because it opens up more trades. It can also be an indication of the degree of risk you take on.
Debt Ratio shows how well a company can pay off its debts with its current assets. It’s found by dividing the total liabilities by the total assets. While debt ratios vary by sector, a number of .5 is a reasonable debt load. A debt ratio of 1.0 tells you the company would need to sell all its assets to resolve the debt. Cheap interest has encouraged many companies to borrow to buy back stock. This makes their price to earnings, or PE, ratio look good. Don’t be fooled. The more secure EV/EBITDA ratio will still reflect the debt.
Highly leveraged or indebted companies may not be able to raise cash in a crisis or a downturn making them more risky.
Dividend Ratio is the percentage of earnings paid to stockholders. It’s found by dividing the dividend per share with the earnings per share (EPS). If they are the same, the number would be 1. If a company retains 50% of their earnings to fund growth, the number would be a .5. At times some companies choose not to cut their dividends, so they may pay out more than they earned. In this case the dividend ratio would be higher than one, say 1.3.
This higher rate is not sustainable for long. Either the company must increase earnings or cut dividends. Be cautious of a company paying large dividends with a ratio significantly above 1
EBITDA means earnings before interest, taxes, depreciation and amortization. This measure shows net income after expenses. It’s used to measure a company’s cash return on investment or ROI.
Enterprise Value (EV) might be considered the takeover price of the company. To calculate the EV, start with total cash and cash equivalents. Then subtract the liabilities of debt, outstanding shares of stock, minority interest, and preferred shares. The less debt a company has, the higher its Enterprise Value is likely to be. But watch out for hidden debt like unfunded pension liabilities, leasing obligations, or other guaranteed payments. This gives you a sense of what the company is worth.
EV/EBITDA may be the most accurate reading of a company’s value. It’s more complete than a simple price to earnings ratio that does not include company debt.
The EV/EBITDA is printed as a fractional percent. For example in the first quarter of 2017, Apple (APPL) had an EV/EBITDA of 10.60 The average ratio is 11.4. Ideally, the lower the number, the cheaper the valuation. Trading stocks with a low EV/EBITA ratio has been shown to lead to more profitable returns than trading based on a P/E ratio alone.22
Find the EV/EBITDA Value
Enterprise Value .
Earnings before interest, taxes,
depreciation and amortization
EPS means Earnings per Share. This indicates how profitable a company may be. It takes the net income from a company (minus the dividends paid) and divides that by the number of outstanding shares. Large sales of equipment, a division, or one-time losses (like settling a lawsuit) might be included or excluded to give a more favourable number. Cash EPS is operating cash flow divided by outstanding diluted shares (all shares possible, including stock options). Operating cash can’t be manipulated so this EPS gives a better indication of the profitability of the company. EPS can be calculated on past numbers using Trailing Twelve Months (TTM) or on forward looking data.
Market Cap is sometimes called market capitalization. It is the total value of all the outstanding shares of a company. It is not necessarily the actual value of the company or its assets. Investors use market cap to determine the size of the company. Large-cap companies are over $10 billion and are usually established, major players. Mid-cap companies are $2-$10 billion and often offer more rapid growth accompanied by increased risk. Small-cap companies are $300 million to $2 billion. They may be early-stage companies or serve a niche market. Since they have fewer resources they often have a higher risk.23
PE Ratio is the price to earnings ratio. The lower the PE, the more value you are getting. It compares the current price of a share to the company’s earnings per share.
The PE shows the price investors are willing to pay per pound of the company’s earnings. If the PE Ratio was 42.5 they would be willing to pay £42.50 for £1 of earnings. Investors may pay a higher PE if they think the company is growing or is going to do better than in the past.
Finding a Company’s PE
Market Share Value
Earnings per Share
If company XYZ cost £20 per share and company earnings were £1 per share, your equation would be:
£20 (share cost) = a PE of 20
Traders may also use the PE ratio to determine if a stock is more or less valuable than in the past. A speculative company’s PE ratios may range from 50 to 300. A conservative utility stock may stay between 8 and 16. If you know your stock typically has a PE ratio between 20 and 30 and it’s now trading with a PE ratio of 18, it may be undervalued and a good buy.
Typically the PE Ratio is based on TTM, the trailing twelve months of earnings. Sometimes the PE will be based on the trailing two quarters and the future two quarters. Or it may be forward looking PE, anticipating the earnings for the next 12 months.
While the average PE Ratio across all assets is 20 to 25, different sectors have different valuations. So it’s most useful in comparing companies within a sector.
Volume tells you how many shares have traded hands and how actively the stock is trading. A higher volume means it’s easier to buy and sell as there’s a lot of interest in trading. A spike in volume may also indicate a more rapid change in price. When you compare current volume to average volume you see if the stock is active or quiet.
4.2 Company Valuation
Company valuation lets you determine if you are paying a high or low price per share relative to the value of the company.
The PE ratio is a quick valuation. However companies can use debt to buy back shares. This makes the PE look better because there are fewer shares, but it overlooks the debt. It can also allow for accounting manipulation. Companies can choose to sell an asset, and add in the profits for a one-time good report. Or they can sell a spin-off that was a losing part of the company, and eliminate that loss from their report.
Wise investors dig deeper. If a company were to sell off all their assets, take the cash, and pay all the debts, what is left? That’s the cash value of the company. Your EV/EBITDA ratio gives you this number.
Value investors look for exceptionally cheap companies that have solid management, a good product, and good prospects. They want to see a high EPS and a PE below 15. They check to see if the product has a ‘moat’ around it. That is, how protected is it from competition? Companies protect themselves from competition by brand name, think Coca Cola or Nike. They may protect themselves with patents as pharmaceuticals do. Or they may have such a huge market share or unique product that makes it nearly impossible or vastly expensive to duplicate. Microsoft and Google fit here.
Ways to increase the probability you will make money with a company include:
- Buying stock when the company is selling at a discount, which means the value of the company is below that of the stock price
- High EPS (earnings per share)
- Low Debt Ratio
- Low EBITDA
- Hedge fund buying
- Analysts’ recommendations
- Pays consistent and increasing dividends
You can find this information on some trading platforms, in the annual reports of a company, or on websites like Yahoo Finance.
Six Ways to Reduce Risk
- Invest in assets that are not correlated to each other. Check historic charts to make sure they don’t fall or rise in tandem. Consider commodities such as oil, corn, or metals.
- Trade CFDs, inverse funds, and assets that can hedge against a downturn.
- Diversify to CFDs and managed futures that let you use derivatives to invest in the rise or fall of a broad range of instruments: Currencies, commodities, stocks, ETFs, indexes, etc.
- Diversify into a range of global equities that may have different cycles and correlations to the UK or your country’s exchanges.
- Research and know the strengths and weaknesses of the equities you choose. Invest in value.
- Keep track of your investments. Check for change in strength, change in trends, upcoming news events, etc., and adjust your portfolio as needed.
4.3 Technical Analysis - Making Sense of Charts and Tools
Charts are valuable tools to help you choose investments. Choose a chart that matches your timeline to see the trends that apply to you. Do you want to hold your securities for a long time? Choose a daily or weekly chart. Want to hold for a few days or weeks? Select a one- or four-hour chart. If you are day trading, you’ll want a one minute chart.
Charts can be shown as a line, a mountain, a set of bars, or as candlesticks. Mountains and lines are good at showing the movement of the security. Candlesticks give you more precision.
Each candlestick represents the timeframe of the chart. So if you are looking at a 15 minute chart, each candlestick shows the maximum and minimum prices reached during the 15 minute interval. The solid bottom and top of the candlestick show the prices at the beginning and end of the 15 minute period. The tails – top and bottom – show the highest and lowest prices in that timeframe.
Experts use candlesticks to help them predict changes in direction. A long tail can show resistance to the price going in the direction of the tail. A candlestick with a very short middle and long ends is called a doji and can indicate a change in direction. When the price begins at the top of the candle and ends at the bottom, the candle is red. If the price starts at a lower level and rises in the candle time period, it is green.
Tools help you make sense of the chart.
Channel: Stocks trend up, down, or sideways. Within that trend, they tend to stay in a range. The range can be broad or narrow. Drawing a channel helps you see that range. To draw a channel, connect the peaks on the top with a line. Do the same with the points on the bottom. Connecting three or more points makes a stronger trend line.
When the security moves above or below the channel line, it’s called a breakout and may signal a change in the trend.
The bottom line of the channel is called resistance. When trading gets to that line, it is more likely to stop and bounce back. The top line is called support as trading often reverses when it hits that line. When a line is breached, that line may change from resistance to support, or support to resistance.
Lines: Sometimes a trend is not formed with equidistant lines. Use the trend line to draw lines connecting as many peaks or valleys as you can. If the trend lines come closer together, a breakout is inevitable. But which way? If this ‘flag’ comes after a down turn, it can be referred to as a bear flag, indicating the likelihood of a continuing downward trend. If it comes after an up-trend, it can be called a bull flag with the idea that the asset will go up. These are simply probabilities. You can look for high probability trades, but there are no certainties or guarantees. The market has a mind of its own.
Fibonacci Lines: This is another way of finding resistance and support lines based on prior moves. A line is drawn between a peak and a valley. Then the mathematical formula comes into play. Your Fibonacci tool draws lines at 23.6%, 38.2%, 50% and 61.8% of the movement in both up and down directions. 61.8% is considered the most powerful line and called the golden retracement. People don’t know why this ancient formula works; just that it seems to be an effective predictive tool.24
Investors look at these lines as a place to take their trade off the table if it bounces there. Or they may have confidence to let the trade run if it breaches the line and keeps going. Fibonacci experts often draw several Fibonacci lines between different peaks and valleys. As these lines overlap, they create a stronger sense that support may be found in that place.
ADX (Average Directional Index): ADX was developed for the currency and commodity markets. The ADX tells you the strength of the current trend but not the direction. A reading below 20 means choppy trading with no clear trend. A reading above 30 shows strong trend movement. Traders use this as one of several indicators that may recommend getting into or out of a trade. When the ADX is high, you have an increased probability that the security will be coming to the end of the trend.
The +DI (plus directional indicator) and –DI (minus directional indicator) help to define trend direction. If the ADX is above 20 and the +DI crosses over the –DI it is considered a buy signal for an upward trend. When the –DI crosses over the +DI (with the ADX above 20), that is a sell signal. With this system, there can be many false stops and starts, so use other trend direction tools to assist your decision. 25
Alligator: Currency traders use trend lines with an alligator metaphor on this chart pattern. Lines together mean the alligator is sleeping, with its mouth shut, so don’t trade. Open lines show an open mouth that’s good for trading. In reality, the lines show trends up, down, or sideways.
All rising lines are bullish. All descending are negative. When the lines cross over each other, it indicates a change in direction. When the lines are close together, it means there is no tradable trend.
The lines are smoothed. moving averages of different lengths. Periods of 13, 8, and 5 are based on the time period of the chart. The Alligator tool will let you set time lengths that suit your trading.
Bollinger Bands®: Bollinger Bands are dynamic indicators that quickly adjust to market conditions. This essential indicator shows recent price changes and measures momentum and volatility. Traders use Bollinger Bands to see the strength and trend of a security and to see when to enter and exit a trade.
Bands expand when the stock is volatile with price fluctuations or strong trends. Bands contract when the stock is consolidating or moving sideways.
Bollinger Bands usually are set at 2.0 standard deviations above and below the price. 99% of all price action falls between 2.5 deviations. So a breakout of the band is a clear trend signal. The center line represents the 20-period moving average. Strong trends have the price closer to the outer edge of the band.
When the price moves away from the outside band and closer to the center, the momentum is fading and the trend may be turning. Candlesticks above the center line show a bullish trend. When the stock price falls below the centerline it is indicating a bearish trend.26
MACD (Moving Average/Convergence/Divergence): This indicator notes the difference between a short period exponential moving average (EMA) with a longer period EMA, usually 12 and 26 days. These lines are shown below the chart. When the short EMA moves over the longer EMA it signals the price is rising higher than it has in the past. This is a bullish sign. Traders may not want to take short positions here.
When the short EMA drops below the longer EMA, it shows prices are dropping faster than in the past, a bearish sign. This may not be the best time to buy. It’s easier to see the trend against a baseline since the MACD is below the price chart.
Traders look for the lines to cross over each other to signal when to enter or exit a trade. They may also look for divergence. When the MACD is moving one direction and the price of the commodity is still moving another, it anticipates a change in trend.
Moving Average (MA): A moving average levels out random price fluctuations on a chart. It is called a lagging indicator because it uses past data. You can choose how long of a period of past prices go into the MA. The longer the period, the longer the lag time. A shorter MA is more responsive and better for short-term traders.
Use moving averages to identify trends, support, and resistance for your trades. When a security is dropping, it could find resistance based on the moving averages. If it drops through the 20 day moving average, the next support might be the 50 day moving average.
As in the MACD, when one MA crosses over another, it signals an up or down trend. You can choose a variety of moving averages. Weighted or exponential moving averages are weighted toward the most recent data. Triangular MA has the extra weight in the middle. [Caption: Moving averages show trends, support and resistance.]
Relative Strength Index (RSI): This index is a momentum indicator. RSI is said to be in ‘oversold conditions’ when the index falls below 30. It shows overbought conditions when the index rises above 70. Traders believe the market is unlikely to sustain itself for long in either an overbought or oversold condition. Like a stretched rubber band, it is likely to snap back to its normal level.
The standard look-back period for RSI is 14. A lower number increases sensitivity to change. Just because the indicator says a security is overbought does not mean it will correct or correct immediately. Securities can continue their current trend while the RSI says it’s overbought or oversold. Sometimes the equity will consolidate and work off the overbought condition before continuing higher. It is just one tool that recommends caution when certain levels are reached.
A divergence between the RSI and the security price may indicate a coming trend change. If the security is making higher highs, while the RSI is making lower highs, that is a bearish sign. If the security is making lower lows and the RSI is making higher lows, it indicates a possible breakout to the upside. Divergences are less trustworthy in a strong trend and a better indicator when they form after overbought or oversold readings.
Use Multiple Charts: At times it’s useful for traders to have several charts on their screen at one time. They may want to see how an asset is trending on a short term chart like a one-minute or five-minute chart as well as on a daily chart. Or they may want to have some leading indicators on the screen. Transports or futures may indicate a market trend for a specific stock. Or index charts may help traders decide when to enter or exit a trade. Finally, some traders prefer to have Bollinger Bands, Fibonacci lines, or other indicators on separate charts so the charts are not too cluttered. eToro helps new and skilled traders see a variety of charts in real time with their new feature called ProCharts.
ProCharts give traders the opportunity to show multiple charts on their screen. It is exceptionally customizable. Traders can choose the:
- Number of charts on the screen
- Chart locations on the screen
- Assets represented
- Time frames represented
Traders can easily move the charts around to better support their unique trading analysis. Once the charts are set up, they will appear the same way each time you access them.
Don’t allow fundamental analysis and chart reading to seem daunting. There are so many tools to help you, it might feel like a lot to take in at first, but take it one step at a time. You will learn to use these tools and they will make you a much better trader. The difference between successful and unsuccessful traders is the skill to know when to enter and exit a trade. These tools help you see the trends and the changes in direction. They are designed to let you know when the security may stop going up or down. Then you may choose to buy and sell at these points, you have a distinct advantage. You are not trading blindly.
None of these indicators are guarantees. They don’t predict the future, they only indicate a probability of a direction. To gain experience, practice on a virtual account. Get a feel for how these tools work and how they apply to the securities you want to trade. Then you can trade with more confidence.
This is a marketing communication and should not be taken as investment advice, personal recommendation, or an offer of, or solicitation to buy or sell, any financial instruments. This material has been prepared without having regard to any particular investment objectives or financial situation, and has not been prepared in accordance with the legal and regulatory requirements to promote independent research. Any references to past performance of a financial instrument, index or a packaged investment product are not, and should not be taken as, a reliable indicator of future results. eToro makes no representation and assumes no liability as to the accuracy or completeness of the content of this publication, which has been prepared utilizing publicly-available information.
eToro is a multi-asset platform which offers both investing in stocks and cryptoassets, as well as trading CFDs.
22 Maverick, J.B., ‘What is considered a healthy EV/EBITDA?’, 25 Jun 2019 https://www.investopedia.com/ask/answers/072715/what-considered-healthy-evebitda.asp
23 ‘Market Capitalization’, Investopedia http://www.investopedia.com/terms/m/marketcapitalization.asp
24 ‘Fibonacci Retracements’ Stock Charts School http://stockcharts.com/school/doku.php?id=chart_school:chart_analysis:fibonacci_retracemen
25 ‘Average Directional Index (ADX)’ Stock Charts School http://stockcharts.com/school/doku.php?id=chart_school:technical_indicators:average_directional_index_adx
26 Rolf, ‘Bollinger Bands Explained– The Best Trading Indicator For Different Purposes’,Tradeciety https://www.tradeciety.com/bollinger-bands-explained-step-by-step/