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Pegging the Fundamentals

brandonwendell
Brandon Wendell
Instructor, CMT

Many traders in India still rely on fundamental analysis in order to select their stocks to trade.  While I do believe that fundamental analysis can be useful, it is not needed for short term trading. Technical analysis will tell you all you need to know about when to buy or sell a stock.  However, if you are planning to hold a position longer than a few months, then an understanding of the company’s health may be useful.

Most fundamental analysis revolves around ratios.  Most traders and investors focus on the Price to Earnings Ratio or P/E Ratio.  The P/E ratio divides the price of the stock by the earnings that company had for the last year.  The resulting number tells us what multiple of earnings the stock is trading at.  This can be useful to determine whether the stock is trading at a high or low multiple compared to other companies in the same industry.  If the P/E ratio is higher than the competitors’ P/E ratios, then the stock is overpriced and is less likely to see prices rise.  If the P/E ratio is low compared to other “like” companies, then the stock is cheap and may be a bargain buy.

Figure 1: P/E Ratio

There are a couple of problems with using the P/E ratio for analysis.  First, you cannot compare unlike companies, such as an auto manufacturer with a bank.  Secondly, a company may have a high P/E ratio and still be a great investment if the growth rate of the earnings is high.  For instance, if the company’s earnings are growing year over year faster than the competition, that may justify paying a little more for the stock.

So how do we analyze companies in this manner?  We can take the P/E ratio and divide it by the growth rate of the earnings for the past three years.  The resulting ratio is called the Price to Earning to Growth or PEG ratio.  Typically, the lower the PEG ratio, the better the price is for buying the stock when considering the growth prospects.  In fact, a bargain growth investor or trader should look for a PEG ratio under 1.0.

Unfortunately, I do not know of any website that shows the PEG ratio for Indian companies.  You will have to calculate it manually.  It is easy to do though.  To find the PEG ratio, I use the Reuters website at http://in.reuters.com.  I go to the Markets section and then India Markets.  Once there I get a quote for the stock I am looking for.

Figure 2: Reuters website

Once the quote is up, I can then click on the “Financials Tab,” to get the desired information.

Figure 3: Reuters Financials

The P/E ratio is located halfway down the page and the growth rate is on the right.  Divide the three year growth rate into the P/E ratio to yield the PEG.

bwendell 20120320 india - yes-peg

You can compare unlike companies by using the PEG ratio to see which investment has the most growth potential for the lowest price.  If there is a negative number for the growth rate or if there is no P/E ratio, then the company isn’t making earnings and is fundamentally weak.  This may be a shorting candidate as would be a stock with a high PEG ratio.

This is not the only way to compare stocks for longer term, but it can be a useful tool for selecting the better longer term trades or investments for your portfolio.

Disclaimer
This newsletter is written for educational purposes only. By no means do any of its contents recommend, advocate or urge the buying, selling or holding of any financial instrument whatsoever. Trading and Investing involves high levels of risk. The author expresses personal opinions and will not assume any responsibility whatsoever for the actions of the reader. The author may or may not have positions in Financial Instruments discussed in this newsletter. Future results can be dramatically different from the opinions expressed herein. Past performance does not guarantee future results. Reprints allowed for private reading only, for all else, please obtain permission.