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Understanding Fundamental Analysis (Part 2)
Education | 19 June 2008
By: Xavier Lim
Articles (51) Profile

In the previous issue, Shares Investment (Singapore) has discussed the concepts of Return On Equity and Return On Assets. This issue, we shall introduce another 3 important financial ratios, namely Earnings Per Share (EPS), Net Asset Value (NAV) and Price-To-Earnings (P/E) Ratio.

EARNINGS PER SHARE

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EPS is generally considered to be the single most important variable in determining a company’s share price. EPS measures the earnings allocated to each ordinary share a shareholder has invested in. In a situation where 2 companies from the same industry has the same EPS, it is appropriate for the person scrutinizing investment feasibility to give more weight to the company which generated the EPS with lesser equity. This can be concluded that the company is more efficient in using its capital to generate income and thus is labeled the “better company”.

NET ASSET VALUE

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NAV is a theoretical value of a company that remains if all the assets were liquidated at values carried on the balance sheet and then all liabilities paid off. This figure is adjusted for bonus and rights issues, stock splits and new share issues. For service provider companies, their assets are usually low as these companies have low assets investment.

PRICE-TO-EARNINGS RATIO

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P/E ratio is a measure of relationship between market value of a company’s shares and earnings from those shares. It reflects the market’s appraisal of the company’s future prospects. Generally, investors expect companies with high P/E to have higher future earnings growth compared to those with lower P/E. Also, it is more useful to compare the P/E ratios of companies within the same industry.

APPLICATION OF NAV & P/E RATIO
Warren Buffet once said: “The basic ideas of investing are to look at stocks as businesses, use market fluctuations to your advantage and seek a margin of safety. That’s what Benjamin Graham taught us. A hundred years from now they will still be the cornerstones of investing.”

Let’s use Benjamin Graham’s (Warren Buffet’s investment teacher) 2 approaches for selecting common stocks that, when applied, adhere to the margin of safety. The first approach is buying a company for less than two-thirds of its NAV. The second approach is to focus on stocks with low P/E ratio. Those stocks that are priced unjustifiably low are usually caused by some macro or micro events, for example, due to the US subprime crisis, a lot of stocks are trading at a ridiculously low P/E ratios (found in page 36 and 37) and high discount to NAV (found in page 51).

However, investors should bear in mind that while seeking a margin of safety for investment, their need to appreciate the qualitative nature of companies is also a must. So if you have spotted a growth company that is trading below its intrinsic value (margin of safety), you may want to consider buying some of its shares. Forget about the market fluctuations, sometimes the best investments are the ones that require you to hold patiently.

Armed with an arsenal of investment knowledge, Xavier is the Senior Research Editor at Shares Investment.

Please click here for more information about this author.


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