This is referred to as the intrinsic value. If the intrinsic value is below the market price then there is an opportunity to but and if the market is above the intrinsic price then there is an opportunity to sell.

When doing fundamental analysis a fundamentalist will often examine the true value of shares in a company based on its assets, earnings and dividends. Once they have come up with a number they will then determine if the share is undervalued or overvalued.

Another example of fundamental analysis might be an economist who examines a country’s currency based on all the underlying economic factors and purchasing parity to determine the true value of that currency against another currency.

Once he has come up with his evaluation he can determine if he thinks the currency is undervalued or overvalued against a given currency.

There are many ways to do fundamental analysis but if I swing trade I usually just look at the stock ratings MSN money gives through their stock scouter option at:

http://moneycentral.msn.com/investor/StockRating/srsmain.asp?Symbol=US%3aapc

If I want to invest I want to have a better idea of the fundamentals then a simple rating so here’s my approach of fundamental analysis:

First, here is the main information I use:

• Trailing, current and forward P/E ratio and the 5year high and 5 year low:

   

  The price earning ratio is just that; the ratio you get if you divide the stock price by its earning. The multiple you get will be used to determine if the company is cheap or expensive.

   

  A trailing PE is a price-earnings ratio based on the most recent 12 months' results. U.S. companies report quarterly, so a trailing PE is computed based on the most recent four quarters.

   

  For example, if the stock price is 20, and quarterly earnings were $.50, $.30, $.90, and $.30 – or $2.00 total – the trailing PE is 20/2, or 10. A trailing PE is used instead of fiscal-year earnings because a trailing PE is more current. For example, if the date is December 30, 2006, the most recent fiscal-year earnings are likely for the year ended December 31, 2005 – nearly one year ago. Notably, the trailing PE is used in stock tables.

   

  But a trailing PE is still an historical number that reflects past performance. In addition to the trailing PE, investors will ordinarily look at prospective (or "forward") PEs as well, which are based on analyst estimates of future earnings.

   

• Rate of growth of revenues: Again pretty straight forward. This info again will be used to compare the company to its peers and to the SnP 500 comnpanies to determine how its doing.

   

• Gross margins: Another important tool to see how efficient a company is, compared to its peers.

   

• Debt ratio: Remember, there are good debts and bad debt so don’t jump top conclusions. Have a deeper look and figure out what the debts are for; but one things remains: if the monthly payments are higher than the cash flow, we have a problem regardless of the type of debt!

   

• Type of company, i.e. secular or cyclical. A secular company is one that is not affected by the economy cycles compared to the cyclical who is

   

  For example, when you do fundamental analysis you need to understand that companies like pharmaceutical companies are not affected by the economy cycle since people don’t need less medications when the economy is doing badly Vs. the aviation industry who is affected both by the economy cycle and by their own business cycle……

   

  You need to know the metric(s) by which the company compares itself with its peers.

   

  All this info is available for free at yahoo finance or msn money or the street.com

So, where to start?

Where ever you find your pick you need to figure out if it’s at “a premium” vs where it is trading at the moment, so you start by identifying the information I outlined earlier to do the fundamental analysis.

You then identify the other major competitor(s) in its industry or the general info for its industry if you can’t identify the main competitor or if the information is not available like for a privately owned company, and get the same information for them.

Finally you will notice that the site where you get this information also offers a comparison with the SnP 500 companies which you compare with your pick and its peers.

A bargain is a company who is growing its sales and earning faster than the SnP average and selling at a lower multiple than the average.

An expensive one trades at a PE higher than the average but grows slower.

Remember when doing fundamental analysis that the market cares about future growth so the price is usually priced base on them so you also need to find the earnings predictions which again you can find for free on the same sites I mentioned earlier. Once you have all of that information you will know more about it than most investors out there.

But it doesn’t end here, to do good fundamental analysis you also need to know how indebted the company is, compared to its peers. You need to know its debt ratio…

Finally, you can do the risk ratio:

You figure out how high it can go based on fundamentals ( here I use MSN money under investing, type in the symbol and go to the financial results/key ratios/price ratios) ie, the multiple at which it is trading compared to where it could go.

For example, If it is below the leader in the industry, you can calculate the PPS if it traded at the same level as the leader or compared to its forward statement. I use the lowest of the two..

If your pick is the leader and already trades at the highest multiple in its industry, I measure it using the forward PE statement So a 5$ company can have less upside opportunity and more downside risk than a 50$ company…BTW, Long term consistent growth warrants the highest PE multiple…

With this fundamental analysis, I can attach a sticker price to the company.

OUF! Don’t worry, it sounds worst then it really is…

Let’s recap from a different perspective:

Let’s assume company X PE ratio is 40 and trades at 6$ with earnings of 0,15$ per shares

Company Y has a PE ratio of 28 and its PPS is 48$. With earnings of 1.71$ per shares

Finally the industry itself as a PE of 30 and finally the SnP average is 29.

I then look at the financial statements of both stocks and look first at the earnings growth rate and then at their respective overall debt ratio. I expect the company with the best spread sheet to be the one trading at the highest multiple, if not, I dig deeper and start by finding the expected earnings and other predictions like the analysts predictions etc,…

Based on the information I dug up I can determine which company is in better shape and see if the multiple at which it trades correlates. If it’s cheaper or priced accordingly I still pursue the matter, if it is way higher I drop it.

I then do the risk /reward ratio. In other words if things go perfectly how high can I expect the price to move up and if things really don’t work out, how low could it go?

So, company X has a PE ratio of 40 already let’s assume nothing indicates there could be major developments that would allow for further increase in earnings in the near future so it won’t likely trade at a higher multiple.

The opposite though is not very promising: It could easily fall back to the industry’s average so the company as a downside of 1.50$ or 25%... (To have a PE ratio of 30 the price has to come down 25% from 6$ to 4.50$... P/E=ratio or multiple.) so the ratio here is 0:150 !!!!

On the other hand the company Y has a lower PE ratio than the industry so if it did trade at par to the industry it would trade at 51.30$ or 11.30$ more ie +28%!!! (1.71 X the multiple of the industry ie 30 )

The down side in this case is determined by the lowest PE it had in the last 5 years as indicated in the MSN money page under key ratio. Let’s assume the lowest it’s been is 26, we have a downside of 3.54$ or 7%.

Thus the risk reward ratio is 11.30:3.54 or 3.19:1 ( Remember the PE ratio is the price of the stock divided by the earnings so a PE ratio of 26 means the price needs to be 44.46$.

This example of fundamental analysis is also used to prove a 5$ stock doesn’t necessarily have more upside than a 50$ stock…

Here’s a real example of how I assess the risk reward ratio to make it easier to understand:

I will use the following stocks: EXXON and Anadarko Petroleum Corporation (APC)

As of June 7th 2007 ( I will use the YAHOO finance and MSN money)

Anadarko Petroleum Corporation (APC) vs EXXON (XOM) vs SnP average

PPS is 50$ vs 83$

Earnings per share 9.27 vs 6.88

Trailing PE ( PE as of this moment vs current PE numbers that show the planned PE for the year.) = 5.4 vs 12.01

Current PE= 9.8 vs 11.9 vs 23.10

Forward PE (Dec 08) 12.39 vs 12.72

5 year high is 18.8 vs 25.3 vs 60.6

5 year low is vs 6.5 vs 10.2 vs 14.9

Growth rate : I use the sales 5 yr annual average = 16.64% vs 12.16% vs 13.09%

Net profit margins= 27% is the 5 year avg vs 8.9% vs 11.6

Debt equity ratio – 1.41 vs 0.08 vs 1.38 Type of business. It is cyclical but not within its own industry, ie not vs the economy. You can see the tendency by monitoring the crude oil prices.

Let’s compare the data

APC is growing faster than XOM and the SnP average 16.64% vs 12.16% vs 13.09%

APC current PE ratio is lower than XOM’s (9.9 vs11.9)

APC’s forward PE is expected to grow by 30% vs XOM’s which is suppose to grow by 7%

APC’s debt ratio is high compared to EXXON’s but about the same as the SnP average.1.41 vs 0.02 vs 1.38.

The type of business being cyclical, good fundamental analysis demands that we identify if it’s an uptrend or a down trend which in this case we can say it is in an uptrend.

OK, now let’s determine a PPS range for both

Let's start with Anadarko:

With the current EPS and a PE that’s even lower than the current reported 5 year low the stock doesn’t have much down side but considering its high debt ratio we still need to be careful so let’s base the possible low using a technical approach. Looking at the chart we see a low around 40$ which would represent a decline of 10$ or 20%.

The upside, based on the forward PE of 12.4 puts APC’s PPS around 114$! A whopping 64$ extra or125%!!! The risk reward ratio is 64:10 or 6.4:1. I don’t really expect APC to trade at 114$ in 1 year but it gives me an idea of what it trades at right now in relation with EXXON.

About EXXON

Current EPS with the lowest PE in the last 5 years gives it a low PPS estimate of around 70$ or -13$ ie 6.88$ X 10.2

The high estimate is 6.88X12.72 which is the forward PE estimates brings the PPS around 87.50, ie an extra 4.50$ for a risk reward ratio of 4.50:13 or around 1:3.

The choice here is quite obvious; Our quick fundamental analysis shows Exxon actually has more downside than upside Vs. APC who has a lot of upside and practically no downside. This situation here is interesting because the current price seems too good to be true so you need to dig further to see why it’s priced so low.

Let's look at its balance sheet found on MSN money; under investing/ statements/ balance sheet/annual)

http://moneycentral.msn.com/investor/invsub/results/statemnt.aspx?Symbol=US:apc&lstStatement=Balance&stmtView

Notice they have made significant acquisitions and it shows in their balance sheet!. The net income also increased but they still need to work on their debt ratio which they have been working on to date so I am confident investing in Anadarko will be rewarding over the next few years.

I will keep a close eye on the Oil cycle at the same time though.

You should know that based on the analysts rating, Zacks average brokerage recommendation is HOLD.

The reason why I say it’s a strong buy is because YOU will have a stop loss in place so you won’t go down with it if it does go down, but if it goes up, you will take advantage of the total move…

Also, you should know the stock scouter found on MSN, gives it a 9 out of 10 …

Having said that, you need to remember something very important about fundamental analysis:

Just because through good fundamental analysis you found out a company was under priced doesn’t mean it is going to go up in the short term the price can be affected by many factors from the market in general to simple manipulation from the market makers…

So stick to your stop loss all the time, period.