Using the “F” word

I’ve asked ValueTrend’s Fundamental Analyst Craig Aucoin, CFA, to write today’s blog.  On Thursday March 12^th at 2:00PM we will be hosting a webinar to discuss/ explore the ValueTrend Investment process, specifically the fundamental side. As a primer to that webinar, today’s blog is an introduction to our fundamental analysis process. We are not afraid to discuss the “F” word – at least when it comes to the analytical discipline that begins with that letter.

Take it away, Craig:

We have a process that utilizes two very distinct disciplines of analysis- Technical and Fundamental. They are brought together into a type of fusion to make investment decisions for the ValueTrend Portfolios.

On this blog you typically read plenty about the technical piece of the process. Ever wonder about the fundamental component?

Our Fundamental process comprises 4 Steps:

1. Sector Exposure
2. Market Capitalization/Capital Structure
3. Financials, Management
4. The Catalyst

A lot of the decisions made on the fundamental side are made with the knowledge that several factors have already been analyzed by Keith from a technical perspective, or via some pre-screened fundamental research analysis. For example the seasonal characteristics, some quantitative elements, also some risk characteristics related to sentiment have been considered. This being the case, the fundamental factors we may focus on include the company’s financials. It’s a good start to look at factors derived from financial statements, and how they relate to the current price of the common stock. This information is used to indicate/ derive a current multiple that a security is trading at. This will be the area of concentration for today’s blog.

For many investors, a common place to start may be the price to earnings (P/E) multiple. What is that? The P/E ratio consists of the Price of the stock at current market levels. The divisor of this multiple is the company’s current trailing Earnings, or its anticipated “forward” Earnings.

Is the P/E ratio useful? Like a lot of things, it depends. The P/E ratio may be a fine metric to use for a company with predictable, positive earnings. On the other hand, it is unrealistic and uninformative to use this metric for many other companies. For example a company that sells and buys assets as part of their business, the use of an earnings metric is more challenging. The company may take write-downs at times, and realize large gains at others. These are just a couple of regular business occurrences that make forecasting earnings for some companies a futile exercise.

What if a company does have some earnings consistency and growth? Can a PEG ratio be useful?  PEG ratio is a price/ earnings to growth ratio. It is calculated as the P/E divided by the expected earnings growth rate in percent.  For example, if a stock has a forward P/E ratio of 10, and has anticipated growth rate in earnings of 10%, it has a PEG of “1.0”.

Some consider that a PEG ratio less than 1 is an indicator of an attractive level. However, the PEG of a stock inherently has some things that need to be questioned.  How realistic is it to assume that the P/E and growth rate can be expected to have a linear relationship?  What about the duration of this growth rate is it expected for 5 years or longer?

The graphic below illustrates an Income Statement and some of the line items we would expect. When we attempt to use this data it must always be in the context of the type of company we are analyzing.

INCOME STATEMENT

REVENUE                                                             (Top Line)

-EXPENSES/COSTS                                                                           These areas can be manipulated/ adjusted/

=GROSS PROFIT                                                                                  judgement is made. As a result fluctuation

-INTEREST

-TAXES

=EARNINGS/ PROFIT/ NET INCOME           (Bottom Line)

Often because of the decisions made in getting to the “bottom line”, not many businesses produce steady or linear earnings that can be relied on to make reliable forecasts.

So… should you be making an investment decision using;

P/E                          or                            P/E/G         ?

Used alone, either of these metrics seem weak, and likely to disappoint. We prefer a more robust process. And this, of course, is where we leave you with a teaser…

To discover more about the ValueTrend Fundamental process, including how to determine when to utilize tools like “P/E or PEG” ratios, please sign up and attend our Webinar.