Equities: how do traders evaluate shares?

Introduction

When selecting stocks for an equity CFD, traders employ a mixture of technical and fundamental methods to assess the value and potential of shares within the market. Fundamental analysis involves investigating a company’s financial health, examining its revenue, earnings, debt levels, cash flow, and growth prospects in comparison with its peers. By examining these fundamental metrics, traders can determine whether a stock is undervalued or overvalued relative to its intrinsic worth and the broader market. This process, known as value investing, is then combined with technical analysis, the study of price action, to find ideal entry and exit points for trades. However, even the best analysts make mistakes, and equity CFD trades always have the potential for losses as well as gains.

Key concepts

Trading isn’t random, and stock CFD traders use theoretical principles to guide their market activity. Traders blend technical and fundamental analysis to come to a decision about when to open a long or short position. Remember, CFD traders do not own the underlying asset, but instead trade the price action of the underlying via the contract for difference. This influences trading patterns: CFD equity traders hold positions for shorter time periods, and so some long-term strategies may be less effective. You still need to understand them though, as the actions of buy-and-hold traders are important to the overall market. Some of the most important concepts used by equity analysts are described below: intrinsic value, the P/E ratio, and return on equity.

Intrinsic value

Intrinsic value represents the true worth of a company’s stock based on fundamental analysis, viewing an investment as a share in future cash flows both as growth and dividends. Investors seek stocks trading below their intrinsic value, looking to benefit from price increases if and when the market corrects itself. Valuation models, like discounted cash flow (DCF) or dividend discount models (DDM), are used to estimate intrinsic value, but none are 100% effective. This process of searching for undervalued stocks is known as value investing, and can be contrasted with contrarian and trend following investment styles. All of these have an impact on the intraday and short-term market trends that equity CFD traders seek to profit from, so you need to understand them, even if you prefer to use technical analysis for your own portfolio.

P/E ratio

The price to earnings ratio or P/E ratio compares a company’s current share price to its earnings per share, indicating how much investors are willing to pay for each dollar of earnings. Calculating the P/E ratio requires using the P/E ratio formula, which is simple: share price divided by earnings per share. A high P/E ratio suggests investors either expect high future growth or the company is overvalued, while a low P/E ratio indicates undervaluation – or potential issues with the company. Standard P/E ratios differ from sector to sector, normally higher in growth areas such as tech and lower in more stable, dividend-paying sectors like utilities.

ROE

Return on equity (ROE) measures a company’s profitability by how effectively it uses shareholders’ equity to generate profits. It shows the percentage of profit a company earns compared to shareholders’ investments. Higher ROE typically signifies better management efficiency and profitability.

P/V Ratio

The profit / volume ratio, often expressed graphically as a P/V chart, shows how much of a product must be sold to achieve profitability. This is very important when comparing stocks that sell merchandise to turn a profit.

Investment styles

Traders may use the same methods to collect and analyse data, but they will act differently. This comes down to investment style, and many different strategies are available. Some of the most important are value, which uses a few value investing metrics to make decisions on under- or overvalued stocks, contrarian, which bets on mean reversions, and trend following. Combinations of the three are also possible, and more niche strategies also exist that can be exploited by skilled traders using contracts for difference.

Value investing

Value investing is a strategy that identifies undervalued stocks trading below their intrinsic value. Investors practicing this approach search for stocks that have strong fundamentals but are priced lower than their intrinsic value. The aim is to capitalise on market inefficiencies where the stock price does not accurately reflect the company’s actual value, anticipating that the market will eventually recognize and correct this undervaluation. This may happen quickly, after a long period, or not at all.

For CFD traders, value investing is useful for identifying stocks that may trade higher, if undervalued, or lower if overvalued. This information can be confirmed with a technical momentum indicator like the RSI. Any fluctuations in the price can be expected to be stronger if they are moving in the direction of the stocks intrinsic value. Because CFD trading is flexible about going long and short, value investing can be freely used to generate buy or sell signals. Traditional equity traders face additional barriers and expenses to opening short positions, a nice demonstration of the flexibility of equity CFDs.

Contrarian investment strategies

Contrarian investment strategies go against prevailing market sentiments and trends. This approach disregards the consensus or popular opinions in the market and seeks opportunities in assets that are currently out of favour or undervalued, even to the point of trading against trends directly. Contrarian investors believe markets overreact, leading to mispricing of assets, and look for breakouts that signal the beginning of a new, opposing trend. By purchasing assets that are currently unpopular or perceived as having poor performance but possess strong underlying fundamentals, contrarians anticipate a future reversal in market sentiment. This strategy requires patience as it might take time for the market to shift to adjust the intrinsic value of these assets, and technical signals can be used to confirm trends that are already losing momentum, and so more likely to reverse.

Stock comparison

One of the most important skills for stock CFD traders is to identify how a given share differs from its peers. Not all stocks trade in the same way, and it is useful to compare company stocks against similar sectors, similarly sized companies, and those that operate in the same geography. This has a direct impact on valuation metrics and price action, so it is essential for an equity CFD trader to identify norms within the sector and geography that the company operates. For example, an international tech company experiencing rapid growth could have a higher P/E ratio while remaining undervalued relative to the market, while a domestic utilities company with the same P/E ratio would be considered strongly overvalued.

This means comparing stocks doesn’t just require looking at the P/E ratio, P/V ratio and other metrics, but comparing them to industry and sector norms. Some stocks are easy to classify, but others, including complex multinationals with many different business lines, may be harder. In some countries vast conglomerates operate across multiple different business lines, with the same company engaging in manufacturing, resource extraction, consumer services and financial services. This makes it very difficult to find a fair comparison to value the stock against.

For equity CFD traders thinking of opening an account, understanding these nuances is vital. Equity traders need to interpret the P/E ratio not just as an isolated metric but within the context of the sector, geography, growth prospects, and market expectations. Comparative analysis allows you to make informed decisions and fairly compare the intrinsic value of different businesses.

Passive investing

Once you understand the influence of value investing and related metrics such as the P/E ratio and P/V ratio, you will have a better grasp of how active equity traders influence prices. But it is important to remember the majority of traded equity volume is not by value investors, contrarian investors or any other type of active investor, but passive trackers and index funds. These buy and sell in order to rebalance portfolios that mimic an overall index, such as the S&P500, and are responsible for a large portion of overall stock holdings and a majority of daily trading volume in major markets.

Because passive investors do not look at underlying fundamental factors, nor calculate intrinsic values of the stocks they hold, their influence on the market is harder to predict. Passive fund trading activity depends on the relative market capitalisation of the largest companies, and their inclusion or removal from indices. Index CFD traders can trade passive indices directly using CFDs, but unlike passive equity fund investors do not impact the market directly. Because passive investors make no attempt at stock valuation, the normal fundamental factors here have no effect, which has the effect of making markets harder to predict.

Summary

Valuation metrics for stocks help investors select equities based on their intrinsic value. CFD traders need to know the same methods if they plan on trading equity CFDs, as although they do not take ownership of the underlying stock the price of the asset will – if fundamental analysts are correct – move in the direction of its intrinsic value. Knowing common value investing metrics such as the P/E ratio will help you set price targets as entry and exit points for your trades. Finally, investors should educate themselves to think rationally about the market and why different participants trade the way they do, and always bear in mind the presence of large passively traded funds that do not follow these rules.

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