The foundational fundamentals

Many technical stock traders tend to clutch up when faced with fundamental data, but in doing so, they rob themselves of a powerful market tool. And it doesn’t have to be difficult. Judging a company’s financial position at a glance comes down to two data points: the price-to-earnings (P/E) ratio, and the earnings per share (EPS).

EPS is a ranking system for stocks, provided by various financial publications and information services, such as Dow Jones or The Wall Street Journal. It’s calculated as a measurement of a company’s earnings growth over the last financial half year, referred back to that of the previous three to five years. The earnings growth is then compared to the growth of all the other companies that are tracked by the publication, and each company so tracked is assigned a value between 1 and 99:
•    A value of 1 means the company grew its earnings better than 1% of the other companies being tracked, hardly a stellar performance.
•    A value of 99 means the company performed better than 99% of the other companies, making it one of the absolute strongest earners in the listing.

With EPS, then, larger numbers are better. Investors and large commercial traders prefer:
•    to purchase stocks with EPS valued above 80; and
•    to short stocks with EPS below 20.

The P/E ratio, on the other hand, is a quick gauge of company valuation. In comparison to EPS, the P/E ratio is a stand-alone data point (rather than measuring one stock against others). However, the P/E ratio can and should be compared to other stocks within an industry sector as part of the trader’s decision-making process.

The P/E ratio provides a thumbnail measurement of whether a stock is overvalued, undervalued, or just about right. It’s calculated by dividing the share’s market price by the actual earnings per share (not the EPS ranking discussed above). This gives a figure that’s denominated in the number of years that must pass before the stock’s earnings equal its share price, e.g., a stock with a P/E ratio of 32 would require 32 years for one share to earn its value, based upon current corporate earnings.

The lower the P/E ratio, the less expensive the stock:
•    a relatively low P/E ratio invites a long market entry, and
•    a relatively high P/E ratio invites a short sell.

P/E ratios are best compared across an industry sector, as sometimes it’s not merely the individual stock that’s overvalued or undervalued, but the sector itself. Some publications or information services don’t bother publishing negative P/E ratios, and some offer forward P/E ratios, calculated from estimated future earnings, rather than those from the most recent fiscal year, called trailing P/E ratios.

With these two data points in mind, even the most fundamental-phobic technical trader can make a general evaluation of a stock’s likely future direction and range.