Easy Fundamental Analysis Part 3

In this video, the speaker explains why traders should bother with Fundamental Analysis at all even if it belongs in the past and appears to have no predictive value. The reason is risk reduction, where risk equals volatility. If you can't view the trading video above, you can watch it here.

He goes on to say that the formula for return on equity answers a number of questions. Since return on equity is net income over owner's or shareholder's equity, the equation tells you if a certain company is making sales and how successfully they are making their profits.

ROE for some companies cannot be calculated, however. This does not mean that the company has no owner's equity, it's most likely that the company has no net income. The speaker says that having no income is not necessarily a bad thing if the trader is comfortable with risk.

If the company has no income, what parameters would allow the trader to estimate the company's value? Parameters are based not on past performance alone, but also on future performance. But the problem with future expectations, the speaker states, is they equal risk, which equals volatility.

Valuing a stock based on what it will do in the future without taking into account impact of past performance will produce volatility.

Another question raised is about context and extremes. Investing in a stock with a very high or a very low ROE means you are investing on “statistical outliers” within an industry group, which should be avoided.

The speaker share his own strategy for selecting stocks. He says that he tends to look for an ROE benchmark that is equal to anywhere between 10 to 40 percent greater than the industry ROE. Information about stocks that fit these specifications is widely available.

This method of filtering ROE allows the trader to look at stocks with fundamental performance while cutting off the extremes. Extremes are pruned to avoid getting into highly speculative stocks. Stocks without a track record of good performance are also taken out of the equation.

The trader is left with stocks that have a high probability of continuing to perform above market standards.

Fundamental Analysis the Easy Way Part 3 Quotes

There are companies out there with an incalculable ROE. Is it because they have no owner's equity? No, it is most likely because they have no net income.

What happens when traders are caught in expectations is: Expectations = risk = volatility.

If you have an ROE that's really really high or very very low, what you are really investing in are the statistical outliers within an industry group.

I set a benchmark of an ROE that is equal to anywhere between 10 to 40 percent greater than its industry itself. You can get a very wide selection of stocks...that have a very high probability of continuing to perform above what we might just get from the market itself.

Submitted by YouTube Trader on Fri, 07/22/2011 - 00:01

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