(or variance) to either buy or sell. Fundamental analysis has been known to include such activities as investigating a firm's 10ks, visiting its managers, and even making assumptions about how the larger macro-events (war, natural disasters, economic shifts, and so on) will affect the true value of a stock (Sharpe, Alexander, Bailey, 1995, 842-45).
In effect, the fundamentalist has his sights firmly set on the future. Malkiel makes this distinction:
Fundamental analysts. . . caring little about the pattern of past price movement. . . seek to determine an asset's proper value. . . related to the rules of the firm foundation theory (Malkiel, 1996, 117).
Fundamental analysts typically use two major tools in determining a stock's value: The P/E Ratio, and the Dividend Yield. The price-to-earnings ratio is probably the market's best-known value barometer, and it is found by dividing a stock's current price by the per-share earnings, or profits, of its issuing company.
The Fundamentalist usually looks at the P/E ratio as the price investors are willing to pay for $1 in corporate earnings. If, for example, a company's profits are $1 per share and that share sells for $20, its P/E ratio is 20-to-1, or 20. Since the P/E ratio shown in most newspaper stock listings is based on "trailing earnings" (usually over the last four quarters) fundamentalists have to predict future P/E ratios based on the projected earnings over the next year. The Dividend Yield measures a stock's annual dividend payment as a percentage of its current price. A fundamentalist views it as an important value indicator because dividends have been driving factors in common stocks' returns. The dividend yield can be thought of as the level of current income investors are willing to accept per investment dollar.
When inflation and interest rates are low, dividend yields also tend to be low. That is usually because investors are optimistic about f...