Microeconomic Analysis and Fundamental Valuation

Microeconomic analysis is crucial for evaluating individual stocks or corporate bonds. It involves the analysis of the economic well-being of a financial entity, rather than just its price movements.

Purpose of Fundamental Analysis

Traders analyze a company's financial statements to determine if its stock constitutes a good investment. Key questions addressed by this analysis include:

• Is the company's revenue growing?
• Is the company making profits?
• Is the company able to repay its debts?
• What is the fair value of its stock in the long run?

A stock's price is driven by the company's ability to grow sales and earnings, as well as the prevailing economic conditions. Downturns in the economy can cause earnings and share value to fall.

Key Financial Statements

The financial makeup of a company is revealed through three primary statements:

1. The Balance Sheet:

   Compares the company's assets (e.g., cash, equipment) to its liabilities (debts) and owner's equity (capital employed). It explains how the company raises money (through debt and equity) to acquire its assets.

2. The Income Statement (or Profit and Loss Statement):

   Reveals how the company earns money. Expenses (such as operational, interest, or taxes) are deducted from total revenue to determine the firm's net profits. Higher net profits generally lead to bigger returns for owners, often paid as shareholder dividends.

3. The Cash Flow Statement:

   Shows how the company uses its cash to operate the business and how much is borrowed from banks or bondholders.

Core Financial Ratios and Their Interpretation

Analyzing financial ratios allows investors to compare companies and assess their health across various metrics. In all ratio analysis, investors should compare the results of one company against its competition.

1. Valuation Ratios (Profitability and Price)

The higher the profitability and potential dividends of a company, the more attractive it is on the valuation side.

• Price-to-Earnings (P/E) Ratio:

  This is the most commonly used valuation ratio. It compares the price of a share to the amount of earnings it generates. It is calculated as:

  $$ \text{P/E Ratio} = \frac{\text{Price Per Share}}{\text{Earnings Per Share}} $$

  It provides a quick idea of how much investors are paying for each $1 of earnings. The best shares to invest in are generally those with the lowest P/E ratios.

2. Dividend Ratios (Returns to Shareholders)

When a company earns profits, the portion not retained (reinvested) is distributed as a dividend payment to shareholders.

• Dividend Yield:

  Measures the return on investment based on dividends. It is calculated as:

  $$ \text{Dividend Yield} = \frac{\text{Annual Cash Dividend Per Share}}{\text{Current Stock Price}} $$

  This ratio measures how many years it would take to recoup the initial investment through dividends (assuming the yield remains constant). The best shares are those with the highest dividend yield ratio.

3. Liquidity Ratios (Debt Repayment Ability)

Liquidity ratios assess a company's ability to pay its short-term debts and still fund ongoing operations.

• Current Ratio:

  Reveals whether a company has enough cash to pay off its short-term liabilities. It is calculated as:

  $$ \text{Current Ratio} = \frac{\text{Current Assets}}{\text{Current Liabilities}} $$

  A low ratio suggests the company lacks available cash, which could hinder operations. The best shares are those with the highest current ratio.

4. Return Ratios (Profit Generation)

These ratios display the company's ability to generate profits efficiently.

• Return on Assets (ROA):

  Illustrates how well the company is employing its total assets to make profits. It is calculated as:

  $$ \text{ROA} = \frac{\text{Net Income}}{\text{Total Assets}} $$

  The higher the return, the better.

• Return on Equity (ROE):

  Measures how much the shareholders earned for their investment (contribution). It is calculated as:

  $$ \text{ROE} = \frac{\text{Net Income}}{\text{Shareholder's Equity}} $$

  The higher the ratio, the better.

5. Debt Ratios (Leverage and Risk)

Debt is a very important element in company evaluation, as it indicates the level of leverage and associated risk.

• Debt Ratio:

  Compares a company's debt to its assets. It is calculated as:

  $$ \text{Debt Ratio} = \frac{\text{Total Liabilities}}{\text{Total Assets}} $$

  Lower values reflect a better situation for the firm. The lower the ratio, the better.

• Debt-to-Equity Ratio:

  Measures the amount creditors have committed versus the shareholders' contribution. It is calculated as:

  $$ \text{Debt-to-Equity Ratio} = \frac{\text{Total Liabilities}}{\text{Shareholder's Equity}} $$

  A low percentage indicates low leverage. The best shares are those with the lowest debt ratios.

While only a few ratios are covered here, these figures provide a fair foundation for understanding fundamental analysis and making educated trading decisions.