One of the most important skills for a long term investor or trader on the stock market is to be able to estimate the fair value of a security. This is the main objective of Fundamental analysis, which uses the company's financial performance and position as the basis for valuation. There are various ways to conduct Fundamental analysis, such as discounted cash flow, dividend discount model, residual income model, etc. However, regardless of the method used, some of the key indicators and data sources for valuation are market capitalisation, revenue and net income.
The fundamentals of a company are the financial information that reflects its performance and profitability. The most basic fundamentals are market capitalization, revenue and net income. Market capitalization is the total value of all the shares of a company in the market. Revenue is the amount of money that a company earns from its sales. Net income is the amount of money that a company keeps after paying all its expenses and taxes.
Market capitalization, revenue and net income are used to calculate other ratios and metrics that provide more insight into a company's valuation. For example, price-to-sales (P/S) ratio is the market capitalization divided by the revenue. It shows how much investors are paying for each dollar of sales. Price-to-earnings (P/E) ratio is the market capitalization divided by the net income. It shows how much investors are paying for each dollar of earnings.
One of the ways to evaluate a stock is to compare it with other similar companies in the same industry. This is called Comparable Company Analysis or CCA. CCA uses various ratios and metrics to measure how a company is performing relative to its peers and the market. The key goal of CCA is to estimate the fair value of a stock based on its fundamentals.
P/S and P/E ratios are commonly used in CCA because they can be easily compared across different companies and industries. They can also indicate whether a stock is overvalued or undervalued relative to its peers and the market. A high P/S or P/E ratio means that investors are paying a premium for the stock, which could imply high growth expectations or low risk. A low P/S or P/E ratio means that investors are paying a discount for the stock, which could imply low growth expectations or high risk.
However, P/S and P/E ratios are not perfect indicators of value. They can vary depending on the industry, the business cycle, the accounting methods and other factors. Therefore, they should be used with caution and in conjunction with other valuation methods and tools.