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Stock prices are supposed to be related to company fundamentals, but in reality there is only an indirect relationship between the two. If the relationship were direct, it would be a relatively simple task to calculate the fair market price for a stock, but fundamentals are merely a starting point for stock valuation, a starting point that is soon forgotten in the heat of the auction market.

It is my observation that fundamentals are virtually irrelevant to the movement of stock prices in the short- to medium-term; however, in the long term fundamentals do drive stock prices, so it is useful to have a rudimentary understanding of how fundamentals work.

The the purpose of studying fundamentals is to determine a stock's value. This is done through the use of some simple accounting formulas.

Book Value

The search for value starts with the basic accounting formula:

Assets = Liabilities + Equity

or

Assets - Liabilities = Equity

This formula is the basis of the company's balance sheet, wherein we subtract total liabilities from total assets to find a company's net worth, commonly called "book value". Another word for "equity" is "capital", so, when you hear reference to "capitalization", there is a thin thread of logic leading back to the equity section of the balance sheet.

Of course book value is a static measure of value, and it only tells us what the net worth or the theoretical liquidation value of the company is at a given point in time. It tells us nothing about a company's ability to generate profits.

Earnings

Another accounting document is the "income" or "profit and loss" statement:

Revenue - Expenses = Net Income (Loss)

The income statement measures company performance over a specific period of time. We subtract expenses from revenues, and at the end of the annual accounting period the hoped for result is that the company has a net profit, which would result in the equity portion of the balance sheet getting larger. Wall Street usually refers to the profit or loss as "earnings".

Price to Earnings Ratio

When we divide the price per share of stock by the earnings per share, the result is the Price to Earnings Ratio or P/E Ratio. For example, if a company's stock is selling for $100 per share and annual earnings are $5 per share, we divide 100 by 5 and get a P/E of 20. The P/E is also referred to as a "multiple". In this case we would say that the stock is selling at a multiple of 20 times earnings.

Another way to think of P/E is that it represents the number of years it will take to get a 100% return on the investment. In the above example it would theoretically take 20 years to double our money. When evaluating P/E, we should keep in mind that it takes about 12 years to get a 100% return when investing money at 6%.

When we attempt to estimate the value of the stock market, the most commonly used benchmark is the P/E for the S&P 500 Index, which, simply stated, is calculated by the total price per share of the 500 stocks divided by their total earnings per share. (Actually, it is calculated by dividing the total market capitalization of the 500 stocks by their total earnings, but the results of each method are quite similar.)

The Earnings Cycle

Earnings are reported every calendar quarter, and the process makes up a substantial portion of CNBC's programming schedule. The reporting usually begins shortly after the end of the quarter and lasts about three months (although 90% of companies will have reported within about six weeks after the quarter end).

Earnings per share (EPS) reported for the most recent quarter are added to the EPS for the prior three quarters, which gives us total earnings for the last 12 months. This is referred to as twelve-month trailing earnings or "TMT", and this is used to calculate the P/E.

Different Kinds of P/E Ratios

The Real P/E for the S&P 500 is based on "as reported" or GAAP earnings (calculated using Generally Accepted Accounting Principals), and it is the standard for historical earnings comparisons. The normal range for the GAAP P/E ratio is between 10 (undervalued) to 20 (overvalued).

Standard & Poors has introduced a version called "core" earnings, which is more critical than GAAP (it expenses options) and will probably become the standard in the future.

Market cheerleaders invariably use "pro forma" or "operating earnings", which exclude some expenses and are deceptively optimistic. Operating earnings became popular in the 1990s as a result of the investment sales industry's desperation to justify impossibly high valuations. They are useless, ignore them. Well, you can try to ignore them, unfortunately the financial media primarily report operating earnings in about 90% of their coverage. Fortunately, the quote systems still report GAAP earnings -- at least I'm not aware of any exceptions to that.

As a public service, and in an effort to keep the game honest, Decision Point reports all three versions of earnings in our weekly posting to Top Advisors Corner, a free area on this web site.

You can also get the most recently reported and projected earnings and price/earnings ratios (P/Es) from the Standard & Poors spread sheet available for download from their web site.

Dividends

When a company has profits, it can (should!) distribute part of them to shareholders in the form of a quarterly dividend. The excepion is when a company is in a growth mode, meaning it needs all it's cash to fund expansion. A stock's yield is the dividend expressed as a percentage of the share price. It is calculated by dividing the total dividend for the last four quarters buy the current share price.

The following chart shows the key fundamental elements of the S&P 500 Index since 1926. It is a good reference to judge what is normal and what is not.