FAQs on fundamental investing & some fundamental investment strategies
1) What is fundamental investing?
Fundamental investing refers to investing activity that is based on the historic and future performance of a company. Typically, an investor should evaluate the financial performance as well as other company’s performance including evaluating the management quality before deciding to invest in the shares or debt of the company.
2) How is the financial performance of a company evaluated for investing based on fundamentals?
A fundamental-based investment strategy is usually completed, keeping in mind, the medium to long-term perspective. Some of the measures that are used to evaluate the historic financial performance of a company include:
a) Prior 3-year or 5-year sales revenue growth
b) Prior 3-year or 5-year operating income and net profit growth
c) The ratio of cash flow to net income over the last 3 years
3) What are some of the financial ratios used to analyse a company?
In addition to the PE ratio, which is the main valuation ratio used by most investors to evaluate a company, investors also evaluate the return ratios for a company. Two of these return ratios include return on equity (ROE) and return on capital employed (ROCE). Return on equity can be further separated into the net income margin, sales turnover ratio and a measure of debt i.e. assets divided by equity. While net income margin is usually driven by factors that are outside the control of the company, the sales turnover ratio can be improved by better asset utilisation by a company.
4) How can an investor use return on equity to make investment decisions?
Return on equity is a measure of how much a company earns in respect to its shareholders’ equity. Generally, a high ROE can be a good sign when investing in a company. However, as one of the ratios that go into the ROE estimate also includes a measure that estimates the extent to which debt is used to finance the operations of the business i.e. assets divided by equity; ROE companies can become high due to the use of large debt financing. Large debt financing increases the riskiness of a company and it would be better to compare the return on equity with the cost of equity. So as long as the difference between the return is positive or is growing over the medium-term, the company may be a suitable investment.
5) What are some of the popular investment strategies?
The two most prominent equity investing strategies include value investing strategies and growth investing strategies. While value investing focusses on selecting companies that have low PE and price/sales and price/book value ratios, growth investing strategies consider investing in companies that are growing their earnings at a moderate to high level over the medium to long-term.
6) Apart from the PE ratio, what are the additional measures that can be used to invest?
For growth companies i.e. companies which are demonstrating a steady, moderate to high growth in earnings over the medium to long-term, one of the measures that an investor can use to assess is a price/earnings-to-growth (PEG) ratio. A PEG ratio is estimated by dividing the current trailing PE ratio with most likely, one-year growth in earnings of the company. Generally, an investor should not pay more than 1.0x in terms of the PEG ratio while investing in a company.