CFD MODULE 6A INVESTMENT STRATEGIES USING FUNDAMENTAL ANALYSIS - COMPANIES

CFD

6a
Investment strategies using fundamental analysis companies

MODULE

CFD MODULE 6A INVESTMENT STRATEGIES USING FUNDAMENTAL ANALYSIS - COMPANIES

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CFD MODULE 6A INVESTMENT STRATEGIES USING FUNDAMENTAL ANALYSIS - COMPANIES

Contents
Fundamental analysis
Fundamental analysis 5

Company analysis
Company analysis Growth anticipation Risk of disappointment How does the market value growth? (P/E and PEG) Dividends Trading around earnings reports Trading around takeover bids 6 7 8 9 11 12 13

Review
Summary Test your knowledge 14 14

CFDs are leveraged products and carry a high level of risk to your capital as prices may move rapidly against you. It is possible to lose more than your initial investment and you may be required to make further payments. These products may not be suitable for all customers therefore ensure you understand the risks and seek independent advice.

CFD MODULE 6A INVESTMENT STRATEGIES USING FUNDAMENTAL ANALYSIS - COMPANIES

Fundamental analysis
In the next two sections, we will cover the most common fundamental analysis techniques and explain how you can use them to help form the basis of your trades. Fundamental analysis is divided into two broad types: company analysis (studying a companys news flow, financials, operations, earnings, debt, etc.) and macroeconomic analysis (analysing economic data such as unemployment, interest rates, monetary policies/meetings, etc).

1
Company analysis
Studying a companys news flow, financials, operations, earnings, debt, and so on.

2
Macroeconomic analysis
Analysing economic data such as unemployment, interest rates, monetary policies and economic announcements.

CFD MODULE 6A INVESTMENT STRATEGIES USING FUNDAMENTAL ANALYSIS - COMPANIES

Fundamental analysis
Fundamental analysis is a very useful skill that traders can use to help them make decisions about trading a given product. Fundamentals are facts that are out in the public domain, including news streams, financial results, new product launches, economic data, director dealings, and other information relating to a product. This information could have a significant impact on the share price of a company or the price of a commodity in the short to medium term, and can be used to the traders advantage.
No matter what sort of analysis you are using, as a short-term trader you need to identify a point at which you are willing to close out a losing position. One of the central themes of successful trading revolves around the preservation of capital. This is not related to a form of analysis that you use, but is instead simply a key characteristic of prudent risk management.

CFD MODULE 6A INVESTMENT STRATEGIES USING FUNDAMENTAL ANALYSIS - COMPANIES

Company analysis
At any given point in time, share prices tend to represent the sum of expectations about the shares value from all investors. A share price represents a balance between the hopes and aspirations for profit of some, and the fear of loss from others. Generally speaking, investors tend to be willing to pay more for shares with expectations of stable and/or growing income streams. Theyre less likely to pay as much for shares where income may be more variable or where the companys future direction is uncertain.
Keep in mind though that the prevailing sentiment of the market can have a major impact on what the market sees as reasonable, in terms of future earnings expectations. In very bullish times they may be wildly optimistic, then they may become too pessimistic in very bearish times. One of the major challenges of the analyst is to be able to look through these factors in order to make a reasonable valuation assessment. However, the analyst must be willing to accept that while their view may be correct, this is irrelevant if the market does not price accordingly. This is further evidence of why all traders must have a good understanding of risk management.

For investors, one of the keys to success is being able to understand what factors influence market expectations and how these can change over time.

CFD MODULE 6A INVESTMENT STRATEGIES USING FUNDAMENTAL ANALYSIS - COMPANIES

Company analysis
A number of factors can impact sentiment towards a company, both positive and negative.

Cost controls
Growth anticipation. The primary driver of a companys valuation is its ability to grow earnings and eventually dividends. There are a number of ways that a company can increase its earnings over time.
A company can also improve its profitability by reducing expenses, although, those that do often run the risk of cutting corners. To measure this, investors often look at administrative expenses, sales and marketing spending, interest, and depreciation as a percentage of sales, to determine how efficiently management is running the business. Looking at operating earnings as a percentage of sales (margin) can also give an indication of the profitability of the company.

Growing the business

There are a number of ways that a company can increase sales. It can do so by entering new markets, entering into partnerships and joint ventures, winning new contracts and customers, developing and launching new or improved products or improving marketing and sales offerings, to mention just a few ways.

Raising prices
During positive economic times, some companies gain the ability to charge higher prices for current products as demand increases. This is particularly significant for resource producers during bull markets for commodities.

CFD MODULE 6A INVESTMENT STRATEGIES USING FUNDAMENTAL ANALYSIS - COMPANIES

Company analysis
Risk of disappointment Operating risks There are many problems that a company can encounter in its day-to-day business. These could include things like machinery breaking down, the entry of new competitors, price wars, input cost increases, adverse economic conditions, losing contracts or customers there are always risks and challenges for any company. Political risk This varies from country to country but relates to the potential that a new government could gain power and implement adverse economic policies such as tax increases, new regulations, asset nationalisations, and other initiatives. Legal risk This relates to the possibility that the company could be sued. This particularly appears in sectors where there can be disputes over patents and intellectual property, which could lead to significant damage awards or injunctions against doing business. Currency risk Companies operating in multiple countries run the risk that increases and decreases in currencies relative to each other could impact the companys revenues or cost structure and may increase or reduce the earnings power of foreign operations, with respect to the home currency. Bankruptcy risk In difficult times, companies with high debt levels can find themselves unable to meet their day to day financial obligations. To determine the financial strength of a company, there are a number of ratios that an investor can analyse. These include: > Debt to Equity = Total Debt/Total Equity. Measures how leveraged the company is. > Times Interest Earned = Operating Income/interest payments. Measures the ability of the company to service the interest portion of its debt. > Current Ratio = Current Assets/Current Liabilities Measures the ability of the company to meet near-term obligations out of current resources.

Its important for investors to recognise that often the sky is not the limit and that there are also numerous risks and factors that could cause a company to lose money or see business decline dramatically. Fear of negative outcomes can limit the upside potential for shares or even cause declines in share price.

CFD MODULE 6A INVESTMENT STRATEGIES USING FUNDAMENTAL ANALYSIS - COMPANIES

Company analysis
How does the market value growth? (P/E and PEG)

Another major question for investors to ask is: how richly is the market valuing the shares of a company, relative to its peers? The reason this question is important is because more expensive shares tend to carry higher expectations and a higher risk of disappointment, whilst companies with low valuations and expectations carry the potential for upside surprises.
The most common measure of valuation is the Price/Earnings ratio which can be calculated as; Example: A company that has a share price of $30 and earnings per share (EPS) of 2 would have a P/E ratio of 15. The P/E ratio gives you an idea as to how much the market is willing to pay for the companys earnings. The higher the P/E the more the market is willing to pay.

Market capitalisation / net income (annual earnings)

or
Share price / earnings per share

P/E Ratio indicative guide:

Price Earnings Ratio 0 10 10 -15 15 20 20 + Performance Guide Potentially Undervalued Fair Value Potentially Over Valued or Growth Stock High Growth Stock

CFD MODULE 6A INVESTMENT STRATEGIES USING FUNDAMENTAL ANALYSIS - COMPANIES

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Company analysis
The Price/Earnings ratio tells you how many years it would take for the company to make its current share price at the current rate of earnings its the payback period, in a sense. Therefore, a higher P/E indicates higher expectations for earnings growth.
In order to be most effective though, the trader needs to be able to make an assessment of what they believe future earnings per share will be, rather than looking at historical earning figures, which are what you will typically see in the newspaper. This takes a lot more work and of course, you can get it wrong, but it does give a much more accurate reading of how fairly the share is priced relative to its earnings. With valuation tied to growth, another key measure for investors to consider is the Price/Earnings Growth ratio, or PEG for short, calculated as:

Current P/E ratio / current rate of earnings growth

So, a company with a 30% growth rate and a 30 x P/E would have a PEG of 1.0, which is widely considered to be the benchmark level. A PEG that is greater than one means that the market is factoring in an even faster growth for the company, which raises the prospect of disappointment, while a PEG of less than one suggests that there may be room for valuation to increase. Keep in mind that PEG results are a projection and can therefore be less accurate.

TIQ TIP
Traders often research low PE shares to identify companies that may be undervalued.

CFD MODULE 6A INVESTMENT STRATEGIES USING FUNDAMENTAL ANALYSIS - COMPANIES

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Company analysis
Dividends Because some shareholders rely on dividends for income, companies that cut their dividends tend to see their shares punished severely by the marketplace, and those that eliminate them entirely tend to lose institutional shareholders who are restricted by policies that dictate that they may only own dividend-paying shares. Because of this, companies tend to only raise dividends to levels that they feel confident that they can maintain over the longer term. This suggests that changes to dividends can give a strong indication of managements expectations of future results. A dividend increase is indicative of confidence, while a dividend cut generally indicates that a company has encountered major difficulties. The dividend yield is calculated as:

Dividends can also have a significant impact on market sentiment. While earnings can be dependent on accounting estimates, dividends represent a payment of actual cash to shareholders. With equity markets stagnating over the last decade, dividends have become a significant component of shareholders income and return expectations.

Dividend per share / price per share

The higher the yield, the higher the current return on your capital from dividends. Whilst a level below one suggests the potential for a cut, which is often further evidenced by a falling share price. Keep in mind that this calculation uses historical dividend payments, so if the actual dividend payment is cut then so too will the yield. To measure the riskiness of the current dividend level, investors can look at the dividend coverage ratio = earnings per share / dividends per share. This measures the companys ability to earn its current dividend. The higher the level, the stronger the potential for dividends to stay at their current level or increase, while a level below one suggests the potential for a cut. One final key note on dividends for investors Once a dividend is declared, there is a cut-off date for those owning the shares to receive the dividend. On the first day of trading where a buyer would not get the dividend, known as the ex-dividend date, the price tends to get marked down at the open by the amount of the dividend.

CFD MODULE 6A INVESTMENT STRATEGIES USING FUNDAMENTAL ANALYSIS - COMPANIES

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Company analysis
Trading around earnings reports Corporate earnings reports tend to attract a lot of attention and trading activity for a couple of reasons. Firstly, while some developments may come as a surprise, earnings reports and the accompanying conference calls tend to be scheduled and publicised well in advance, so that investors and media are watching for the results. Secondly, analysts tend to publish estimates for earnings in advance, so the consensus of expectations tends to be priced into shares ahead of time.

Because of this, trading around earnings reports tends to be less influenced by the actual level of earnings and more by how reported earnings turned out relative to market expectations. Managements estimates for future quarters, widely known as guidance, can also have a big impact on investor sentiment. Share investing ahead of a report can also be important. A rally heading into earnings news may suggest growing expectations and a higher risk of disappointment, whilst a sell off before the news suggests a lack of confidence and the potential for a positive surprise.

With so many investors and the media focused on the earnings and guidance numbers, there can be significant volatility following the release of earnings data which is why many companies, particularly in the US, tend to report outside of market hours. These reports can have an impact on trends as well and can therefore create significant opportunities and turning points for investors.

CFD MODULE 6A INVESTMENT STRATEGIES USING FUNDAMENTAL ANALYSIS - COMPANIES

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Company analysis
Trading around takeover bids

Takeover bids can create a lot of excitement and volatility in the marketplace, which can create opportunities for trading. There are a number of factors that can influence how shares respond to takeover bids.
Target company Since buyers usually pay a premium to take over a company, shares of the target company tend to rally on the news. Sometimes they rally on rumours before-hand, but rumours can be difficult to trade, as many turn out to be false. The extent to which the target company rallies depends on the nature of the bid and the potential for other bidders getting involved. In a friendly takeover, the target usually trades just below the bid price. In a hostile or contested takeover (i.e. multiple bidders) the target tends to trade higher than the bid price on speculation that a higher offer may emerge. Purchaser Shares of the purchaser tend to decline on the announcement of a takeover bid, which tends to create risks for the buyer, such as: > Overpayment risk The potential that they may overpay for the acquisition or get dragged into a bidding war which could cause the buyer to underperform in future years. > Transaction Risk The risk that the transaction may fail. Also that the transaction may distract management from running the day-to-day business as usual, causing its performance to falter. > Integration risk The risk that corporate cultures may not merge smoothly or that projected synergies may not be achieved. If a takeover transaction subsequently fails, these effects can reverse themselves. Finally, a takeover bid can cause other companies in the same industry group to also rally as speculation grows that other transactions in the group may occur.

CFD MODULE 6A INVESTMENT STRATEGIES USING FUNDAMENTAL ANALYSIS - COMPANIES

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Summary
Now you should be able to:

> Understand how companies seek to increase their profitability > Understand the risks companies face > Calculate PEG ratios > Recognise the risks and rewards of trading around earning reports and takeover bids.
Name three things a company could do to drive growth. Name five risks to a companys profitability. How do you calculate a companys PEG ratio? How do you calculate a companys dividend yield? What are the main three risks for the purchaser of a takeover bid?

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CFD MODULE 6A INVESTMENT STRATEGIES USING FUNDAMENTAL ANALYSIS - COMPANIES

14

Summary
Now you should be able to:

> Understand how companies seek to increase their profitability > Understand the risks companies face > Calculate PEG ratios > Recognise the risks and rewards of trading around earning reports and takeover bids.
Name three things a company could do to drive growth. Growing the business, raising prices and cost controls. Name five risks to a companys profitability. Operating risks, political risk, legal risk, currency risk and bankruptcy risk. How do you calculate a companys PEG ratio? PEG ratio = Current P/E ratio / current rate of earnings growth. How do you calculate a companys dividend yield? Dividend per share / price per share. What are the main three risks for the purchaser of a takeover bid? Over payment risk, transaction risk and integration risk.

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