It may seem strange to find a lesson on fundamental analysis within the scope of this "Technical Talk" section. As you view the title of this article, you may be wondering what fundamental analysis and technical analysis have in common. These two forms of analysis approach market forecasting in drastically different styles; can they be combined? Fundamental analysis involves identifying the important variables essential to price action, while technical analysis endeavors to obtain tradable information from price action itself. What I find most curious is the desire of analysts to rely exclusively on either fundamental or technical analysis.

An approach using only fundamental analysis is unable to adjust to the frequent changes of market conditions, just as the sole use of technical analysis does not take into account the influential presents of the core fundamentals on market prices. These two forms of analysis should not be viewed as conflicting styles of investing, but rather they should be regard as balancing one another, each complementing the other.

Those of us at IncomeTrader (IT) believe in using fundamental analysis to select quality stocks and then we use technical analysis to time our trades. We believe even the reactionary Day Trader can profit from an understanding of fundamental analysis. So, with that understanding we will cover some typically fundamental "Valuation Ratios" that we view as important and often refer to in our newsletter.

P/E Ratio (TTM) - The Price/Earnings ratio is calculated by dividing the stock price by the trailing twelve-month (TTM) earnings per share. Earnings per share for the P/E ratio are determined by dividing earnings for the past twelve-months by the number of common shares outstanding. The P/E ratio shows how much an investor must pay to "buy" $1 of the company's earnings. For instance, if a stock is currently trading at $30 and the earnings per share for the last four quarters were $3; the P/E ratio is 10 (30 / 3 = 10). What this means is that in order to buy $1 of the company's earnings you must pay $10. Normally, the P/E ratio of the company is compared to its industry; the company with the lower P/E ratio represents a better value.

Price to Sales (TTM) - The current price of a stock divided by sales-per-share of the company for the trailing twelve-months (TTM). Sales-per-share for the P/S ratio is determined by dividing the income of the last twelve-months by the number of shares outstanding. 

Price to Free Cash Flow (TTM) - The current price of a stock divided by the trailing twelve-months (TTM) free cash flow-per-share. Free cash flow-per-share is determined from the statement of cash flows as cash from operations less capital expenditures and dividends paid.

% Owned Institutions - This is the percent of common stock held by all the reporting institutions as a group. The total shares owned by institutions divided by total shares outstanding multiplied by 100. Institutional investors included insurance companies, depository institutions, pension funds, investment companies, and endowment funds (funds established to support institutions such as schools, hospitals and foundations).

Sales (MRQ) vs. Qtr.1 Yr. Ago - This value is calculated as the most recent quarterly (MRQ) sales minus the sales for the quarter one year ago divided by the sales for the quarter one year ago and multiplied by 100.

Sales (TTM) vs. TTM 1 Yr. Ago - This is the percent change in the trailing twelve-month (TTM) sales as compared to the same trailing twelve-month (TTM) period one year ago.

Sales - 5 Yr. Growth Rate - This growth rate is the compound annual growth rate of sales over the last five years.

EPS (MRQ) vs. Qtr. 1 Yr. Ago - This value is calculated as the most recent quarterly (MRQ) EPS minus the EPS for the quarter one year ago divided by the EPS for the quarter one year ago and multiplied by 100. EPS is the company's profit divided by its number of shares. If a company earned $2 million in one year and had two million shares of stock outstanding, its EPS would be $1 per share.

EPS (TTM) vs. TTM 1 Yr. Ago - This is the percent change in the trailing twelve-month (TTM) EPS as compared to the same trailing twelve-month (TTM) period one year ago.

EPS - 5 Yr. Growth Rate - This growth rate is the compound annual growth rate of earning-per-share excluding extraordinary items and discontinued operations over the last five years.

Current Ratio (MRQ) - This is the ratio of total current assets for the most recent quarter (MRQ) divided by the total current liabilities for the same period. This indicator represents the short-term debt paying ability of the company. The higher the current ratio is, the more liquid the company. For example, a current ratio of 4.0 means that the company's current assets, if liquidated, would be enough to pay for four times the company's current liabilities.

Total Debt to Equity (MRQ) - This ratio is total debt for the most recent quarter (MRQ) divided by total shareholder equity for the same period. It compares the assets provided by creditors to assets provided by shareholders, and is a good indicator of the company's financial leverage. This ratio evaluates the extent to which total assets have been financed with debt. For example, a debt ratio of 30% indicates that 30% of the company's assets have been financed with borrowed income.

Net Profit Margin (TTM) - This value expressed as a percentage is also know as, return on sales (net income), it is the income after taxes for the trailing twelve-months (TTM) divided by total revenue for the same period. This indicator is useful in determining a company's profitability. For example, a net profit margin of 20% indicates that $0.20 of every $1.00 in sales is realized in profits.

Figure 1: Valuation Ratios.

Figure 1 is a table of valuation ratios for Homestake Mining Company [HM]. This chart was taken out of the "Stock Picks" section of the Sunday edition, October 28^th issue, of IncomeTrader (IT). When looking for strong or weak stock picks to trade, we first take a look at the recent news and the fundamentals to obtain an idea of the strength and quality of the security we are examining before we go onto the stock's technical outlook.

When determining the value of the stock we like to study the condition of the company as related to its industry and the economy as a whole. That's why you'll see in the above chart a listing of the company's valuations next to the industry's valuations. From this quick synopsis we can acquire a good feel as to the strength of this stock. By only viewing those fundamentals that we believe will provide us with a clear picture of a stock's depth and direction, we avoid that all too common problem know as, "Paralysis of Analysis." This is the phenomenon in which you spend all your time learning every fundamental detail of the stock and therefore you never have any time to actually make a trade. As a stock and options trader, our goal isn't to know every minute detail about a stock (to the point that it interferes with our trading), our goal is to make money and fundamental and technical analysis are just tools that allow us to do so.

After quickly comparing the fundamentals of our stock to its industry, we are able to determine if this is a stock we should go forward with or reject and look for another candidate. If we like the company's fundamental valuations, then we will study its price chart and technical indicators to time our entry.

Note: the NM in the above chart means "not mentioned."

Approaching the market place with an understanding of both fundamental and technical analysis can only help you become a better trader. Fundamental analysis reveals fundamental valuations and trends (economical, political and ecological), while technical analysis exposes psychological factors, volume and price movement. These two methods of trading when used in agreement will often signal, to the watchful trader, the direction and the timing of the next powerful price movement.

Chris Coval

Technical Editor chris.coval@incometrader.com