With depressing regularity, investors have to be reminded of the fundamentals of stock picking. This is such a time. Not too long ago, we were told that technology stocks did not have to follow the rules, they were different. Internet and technology companies might be losing millions of dollars but, using the "innovative" methods of measurement, they were worth billions. Now technology and Internet stocks have slumped around the world. Things weren't so different after all. It is to be hoped that the lessons, learned the hard way, will not have to be re-learned when the next craze comes along to join Internet stocks, red chips and H shares as the flavour of the week. What investors should have learned is that fundamentals still count. Don't buy a stock on rumour, or on the shallow advice of a friend. Make some simple calculations and comparisons to judge the real value of a stock.
So where do I start?
Start with the key long-term guide to a company's health - earnings.
These are what is left after all the expenses and costs are subtracted from revenue. You can find them in the annual report or prospectus.
Earnings only tell you how the company has been doing for itself, but they don't tell you how it has been doing for the shareholders.
For that, you may need the earnings per share (EPS), representing the earnings divided by the total number of shares in issue. Earnings might be going up, but the EPS could be going down, because the company has been issuing additional amounts of shares. That dilutes the interest of the shareholders and reduces the amount available to each one.
Look at how the historical EPS has performed over, say, three years to see how well a company has been doing for its shareholders. Then you can make comparisons with other companies in the same industry or sector, and a picture of relative performance begins to emerge.
Does the share price reflect the earnings?
To get the market's view on a company, you may need to look at another tool - the price/earnings (P/E) ratio. Take the share price, divide it by the EPS, and you have the P/E ratio. The current P/E ratios are published in the stock price columns of many local newspapers.
Now you can see how a company is valued compared to the market or other companies in the same sector. A relatively high P/E may reflect an optimistic view about the prospect of the company. But, it may also mean that the company is over-valued or over-priced relative to other companies with similar attributes.
Remember you are looking at historical P/E's. Most analysts use prospective P/E's, so always be aware of which figures you are looking at. A company's share price might be so strong that its P/E seems very high, but if earnings are set to increase, then it begins to look more attractive.
What is a dividend?
It's the share of the profits paid to the shareholders. The amount is usually expressed as cents per share. Like earnings, the history of dividend payments can be a guide to the efficiency of a company.
What do I need to know about dividends?
That depends on what you are looking for. If your aim is capital gain, then dividends are less important. If you are investing for retirement and want an income stream, then dividends are very important indeed.
How do dividends help me to evaluate a company?
Through the dividend yield. You take the total dividend - there may be more than one payment a year - and divide it by the share price. That gives you the yield in percentage terms. Once again, you have a tool for comparison.
Don't be fooled by an apparently very high dividend yield if you are looking for income. This could be due to the slump in share price since the last year's dividends.
If you look at the average dividend yields and P/E ratios for the whole market, and then track them back, you will have a good guide to how high or low the market currently is in historical terms.
How about book value?
This represents the total amount of a company's assets minus liabilities and, if issued, preferred stock. Once again, you can build a comparison tool by dividing the book value by the share price, giving the book-to-price value.
A good company selling below the book value might be a bargain, but it isn't that simple. Prospects of bleak earnings in the future may be one reason why the price is so low.
Is that all?
Far from it, these are just the very basic building blocks of fundamental analysis. To get a better understanding of the financial healthiness of a company, take a look at the key figures contained in the profit and loss account, balance sheet and consolidated cash flow statement as well as the auditors' report.
Apart from these numeric tools, you also need to evaluate the qualitative factors, such as corporate governance, management quality, industry outlook, market share, competitive edge and business plans.