Well, I've been talking a lot about stocks for the past few weeks and pretending I know what's going on in the market.  If you've been following this blog, you might be wondering, "What exactly is he basing all this stuff on?"  So, I'm going to tell you.

There is a special subset of the vast range of data available about any company, which you'll hear stock gurus refer to as the "fundamentals".  Now, I have looked at the fundamentals sheet for a lot of different stocks.  Certain patterns naturally emerged.

First, we'll look at the valuation ratios, i.e. P/E and P/S.  Typically, a good stock is one that has low positive values for both the price-to-earnings and the price-to-sales.  On average, all the companies worth buying into have had both of these ratios less than 20.00.  Some companies might have a P/E higher than 20 but a P/S lower than 1, and these can be decent choices too.  For a quick calculation of stock potential, average the P/E and P/S values together.  If the result is less than 20, the stock is decent; if it's less than 15, it's good; and if it is under 10, seriously consider buying right away.

Next, we come to the uses of the Per-Share data.  Earnings and sales are already wrapped into the P/E and P/S ratios.  Cash flow is the key number here that you need to evaluate, especially if the company provides a dividend.  The cash flow is given as TTM, meaning the cash flow so far this year.  To find out whether their cash flow covers their annual dividend, don't multiply the cash flow - there's no telling what will actually happen.  Instead, divide the annual dividend cash amount according to how far into the year it is, and compare it to the current TTM cash flow.  If the partial dividend exceeds the TTM cash flow, that's a red flag.  It means that unless something changes, the dividend will be cut.  Now, something may change, but predicting change is much harder and more tenuous than using existing data as proof.

The third group of numbers describes management effectiveness, i.e. the company's return on various investments they make with the capital they have.  These numbers are given as percentages.  Most of the stocks out there, except for investment trusts and the ilk, tend to have less than 20% on average over all three numbers in this group.  So, "good numbers" in this section are any higher than 20%.  For non-investment-oriented companies, however, seeing a very large value for any of these can be a bad sign.  Why, for example, should an automotive company with around 15-20% in their returns on equity and assets have a 264% return on investments?  Stockbrokers and other people who invest for a living would be hard pressed to get 264% returns.  A healthy company will probably have these numbers between 25 and 30 percent, on average.

The final group of numbers is about profitability.  These numbers, unlike those of the other groups, have nothing to do with the average profitability of other stocks.  Each and every stock should be gauged by itself in this regard.  Thus, the rule here is simple: as high as possible, making sure that the gross margin is higher than the profit margin.

That's the idea of the fundamentals in a nutshell!  Happy investing!