While one is always looking for rewarding stock ideas, the sheer number of companies in the equity ecosystem can be overwhelming and confusing. However, did you know that you could narrow down your long-term investing choices by simply using fundamental analysis and ratios?
For the uninitiated, fundamental analysis is usually undertaken to find out the intrinsic value of a stock or an index. It helps investors find stocks trading at a discount to their true value. A part of fundamental analysis revolves around financial ratios that are used to compare stocks with peers and within an industry. While fundamental analysis may not guarantee a stock’s future success, it can certainly serve as a useful tool to analyse the financials of a company, a sector or the index itself.
Here are some of the key investment ratios to help you better undertake fundamental analysis. These can be applied to stocks, sectors and indexes.
Price-to-earnings ratio: This is the most common valuation metric in fundamental stock analysis. The higher the P/E, the more speculation is priced into the value, usually from bullish expectations for the future. Lower P/E is usually more reasonable but can also indicate potential undervaluation if it is considerably lower than its peers. The forward 12-month P/E ratio for S&P 500 is 21.5 and above the 10-year average of 15.8. The increase in earnings comes in as most companies have beaten EPS estimates during the first-quarter earnings season, resulting in higher forward P/E for the index.
Exhibit 1: Forward P/E for S&P Indexes
Data as on April 2021/Source: Yardeni Research
S&P 500 vs. Sectoral valuation metrics
Forward P/Es are one of the popular valuation metrics to assess the fair value of a stock or a sector. The valuation metrics in Exhibit 2 helps an investor assess the fair value of the sector as compared to the benchmark S&P 500 12-Month Forward P/E. Financials, Healthcare, Utilities, Energy sectors all look attractive with a lower than the S&P 500 forward P/E of 21.6 (Exhibit 2) at current levels. Some sectors like consumer discretionary, IT, Industrials have higher forward P/E of over 25 based on their earnings, which are largely dependent on the industry or the specific environment in which they operate.
Exhibit 2: Sector-wise valuation ratios
Data as on 7 May, 2021/ Source: Factset.com
Assessing the financial strength of S&P 500
When we look at the quarterly financial ratios of S&P 500 in terms of the working capital position or the leverage ratio for 1Q 2021, they are maintained close to the average ratios of each metric. The proportion of debt to that of equity shown in Debt-to-Equity ratio is also very low at 0.03 for 1Q 2021, compared with the average of 0.33 (Exhibit 3). This explains the financial strength of S&P 500 companies and its ability to service their debt components.
Exhibit 3: Financial Strength of S&P 500
Data as on April 2021/ Source: CSIMarket.com
Note: All ratios are on the trailing twelve month (TTM) basis
Profitability Ratios
These ratios help an investor decide the stocks or sectors that can be most profitable when invested and assess his returns potential compared with the industry’s average returns. Listed below is the net profit margins of various sectors of the S&P 500 for Q1 2021 which shows Real estate, IT, Financials and Communication services being most profitable during Q1 2021 with higher net profit margins.
Exhibit 4: Net Profit margins for S&P 500 sectors
Data as on 7 May, 2021/ Source: Factset.com
Quality over momentum
Most of the stock returns in 2020 were from the momentum stocks (Exhibit 5), as they sold stories by keeping aside the fundamentals or the financials of the firm. The bad news for investors considering momentum investing is that the herd is often wrong; at any given point if the stock reverses, the investor can witness hefty losses. However, it’s a different story for good-quality stocks with strong fundamentals, and this explains why value stocks are coming back to strength in 2021 (Exhibit 5) with profit-booking seen in most momentum stocks.
Exhibit 5: Value, Momentum and quality stocks returns (2014-2021)
Data as of April 2021/ Source: S&P Global, Index Dashboard
Look beyond the numbers
There’s more to analyzing a potential stock than just looking at valuation metrics and ratios. It is far more important to invest in a good business than a cheap stock. Some of the other essentials of stock analysis include:
Industry trends: Investors should focus more on industries that have favorable long-term growth prospects. Sectors like E-commerce, cloud computing, healthcare, infra and capital goods, clean energy, electric vehicles are all examples of industries that are likely to grow significantly in the years ahead
Management: It doesn’t matter how good a company’s product is or how fast they are growing. Companies with good management are key to make critical decisions as their extensive industry experience and financial interests align with the shareholders.
The Takeaway
The market is a huge gossip mill. So, it is important for investors to look at fundamentals and value of the company for long-term investing. And, a basic knowledge of fundamental analysis will help investors lay a better foundation to make informed investment decisions.