Chapter 16. Fundamental Data

There are three ways of deciding which shares to invest in:

1. fundamental data

2. charting

3. gut feeling.

The best policy may be to take a combination of the three. The more you invest the better your judgement will become. Fundamentals are based on hard facts about the company; charting follows movements in the company’s share price; gut feeling is something that cannot be easily defined or taught.

If you get a feeling that a company is heading for trouble or is about to turn the corner, and you find that nine times out of ten you are right, by all means follow your heart. Otherwise it is probably best to stick with what is more tangible.

Fundamentals are the figures that the company puts out in its profit and loss account and in its balance sheet, plus the calculations that you can make with those figures.

Through the fundamentals you can work out whether shares look good value.

Historic and prospective data

Figures published by a company cover periods of time that have elapsed. Their main advantage is that they are real figures. They tell you what really happened. But they are historic. They do not in themselves tell you what will happen over the coming months.

Analysts employed by stockbrokers make forecasts covering up to 24 months ahead. These forecasts are referred to as prospective, future or forward. They have the big advantage of telling you what is likely to happen to revenue and profits so you can assess how share prices will be affected in the future. However, they are only forecasts, not actual figures, and they can be wrong.

Larger companies are researched by several analysts and it is possible to get a consensus or average view of expectations. Smaller companies may be researched by only one or two analysts, or there may be no forecasts at all.

On balance it is better to rely on prospective data because you are buying shares for future, not past, earnings – but there is no reason why you should not consider past and forecast earnings when making investments.

Ratios

There are two particularly important pieces of fundamental data that you should consider when deciding to buy a company’s shares: dividend yield and the price/earnings ratio.

Dividend yield

The dividend yield is particularly important if you are looking for steady income from your shares.

Do not assume that large dividends in terms of pence per share are necessarily more attractive. If the shares are more expensive then you need a bigger dividend to make the investment worthwhile.

Let us suppose that the shares in company A cost you 100p and the company pays a dividend of 4p. For every £100 you put in, you get 100 shares and the dividend you receive will amount to £4. The yield is 4%, that is £4 on every £100 invested.

Shares in company B cost 200p each and the dividend is 5p. Although the dividend is 1p higher than at company A, the yield is only 2.5%.

For every £100 you invest, you get only 50 shares so you receive only £2.50 in dividends. The yield is therefore 2.5%, or £2.50 for every £100 invested.

You can calculate the yield on any share quite simply by dividing the dividend by the price of the shares. Remember that both figures must be in pence (or, if appropriate, in euros or US dollars) so you are dividing like with like.

You can use the historic figures to get the historic yield, or analysts’ forecasts to calculate the prospective yield.

It is difficult to obtain forecasts without paying either a stockbroker or financial website for the privilege. Newspapers sometimes give prospective yields when reporting company results but this is not comprehensive.

However, when you see first-half results from a company you can easily see how much the interim dividend has been increased by. Unless the company says otherwise, as discussed earlier, it is reasonable to assume that the total dividend will be increased by a similar percentage.

In the table below I have taken the share price of five stocks on a specific day and used the interim dividend to calculate the prospective yield.

Table 18: Calculating the prospective yield

Source: Company results

Lloyds banking group was still recovering from the trauma of the 2008 crash when the ill-advised takeover of smaller rival HBoS forced Lloyds to seek government help. Having restored its dividend at a low level, it was ramping up the payments, hence the large gap between the yield based on the previous year’s dividend total and the prospective yield for the current year.

Water supplier Pennon, and Whitbread, owner of Premier Inns and Costa Coffee, were also moving in the same direction, though less dramatically.

Pharmaceuticals giant GlaxoSmithKline had made clear that its dividend would be unchanged in the current year, so the historic and prospective yields were identical. This yield was well above the stock market average of about 3.5%.

Figures for construction and facilities management group Carillion were distorted by a series of profit warnings that had pushed the share price below the previous year’s dividend. Historic yields of more than 7% should be treated with extreme suspicion as the market may be expecting a dividend cut. Carillion had already suspended the dividend.

The higher the yield, the greater your income for every pound invested. You may wonder why some companies have much higher or lower yields or dividends than average.

Companies look cheap when there are doubts about how well they will fare in the future, while others look expensive because the market sees them as good investments that are highly likely to grow in value.

If there are reasonable hopes that the dividend will continue to rise for the foreseeable future, investors may be happy with a low but solid yield. Where there are serious doubts about a company’s profits, and the possibility arises that the dividend will have to be cut in future, investors will want a higher yield in the meantime to compensate for the extra risk.

Remember, the stock market is about risks and rewards. The greater the risk, the greater the reward you are entitled to expect if it all comes right in the end.

Price/earnings ratio

The second vital figure, particularly relevant to those looking for capital gains rather than income, is the price/earnings ratio, often referred to as the rating because it indicates whether the shares look cheap or expensive.

This ratio (usually abbreviated to PER or just PE) is calculated by dividing the price of the shares by the earnings per share after tax.

As with yield, you must divide pence by pence, dollars by dollars, or euros by euros. But unlike the yield, where you get a better return from a higher figure, the price-earnings ratio identifies cheap shares as the ones with a lower figure. The lower the PE, the cheaper the share.

Also, as with the yield, a historic PER can be calculated from historic earnings per share, while a forecast PER can be calculated from forecast earnings per share.

Unfortunately it is not possible to calculate full-year earnings accurately from interim figures as the second half may turn out quite differently from the first, especially for those companies with seasonal businesses.

Newspapers often report future PEs when covering company results in their investment columns – such as Lex in the Financial Times, Tempus in The Times and Questor in The Daily Telegraph – but this is rather hit and miss. If you want comprehensive access to future PEs you will almost certainly have to pay a broker or a financial website’s subscription fee.

Generally, companies growing quickly tend to have high PE ratios, while slow-growth companies have low ratings. Certain industries (e.g. technology-related) tend to be regarded as high growth and therefore attract high ratings; whereas other industries (e.g. utilities) are traditionally viewed as low growth and have low ratings. Companies in the same industry tend to have similar ratings. However, anomalies do occur and, as with the yield, a company’s rating may look cheap for good reason. A lowly rating can indicate concern over the company’s prospects, while a high rating reflects confidence.