The first company we are going to look at is a rapidly growing software developer operating in a niche market - Jumbuck Entertainment. Listed only less than 12 months ago, the company's share price has quadrupled from 20c to 80c. Jumbuck develops games and messaging applications for mobile phones, which it licenses to over 35 telecommunication carriers in 5 continents. The telcos provide Jumbuck's applications to their mobile phone customers for a fee, and the revenue is shared between the telcos and Jumbuck.

In this tutorial, we will look at some basic tools and techniques of fundamental and technical analysis and apply them on Jumbuck to see how well this company stacks up as a potential investment.

RELATIVE VALUATION - From your broker's research, you could easily obtain the Price-Earnings Ratio (PE ratio). However, historical PE ratio (i.e. PE ratio calculated from last financial year's net profit) is of limited information value especially in the case of a rapidly growing company like Jumbuck because profit growth is so fast, last year's profit has no bearing on next year's profit. Since Jumbuck released an updated profit guidance (NPAT $2.55-$2.60m) on 24 June 2005, we will use that profit figure instead. Now take out your calculator or use a spreadsheet to calculate the Earnings Per Share (EPS). EPS = Net profit $2,575,000 divided by 43,162,448 shares. You should get an EPS of $0.0597. Use this figure to calculate the PE ratio. PE = Share price $0.80 divided by EPS of $0.0597 = 13.41.

One way to think of PE ratio is, it estimates the number of years a company takes to accumulate a net profit equivalent to the current share price valuation. So, in the case of Jumbuck, if it maintains its current EPS it will take the company 13.41 years to match its share price. The higher the PE, the more "expensive" a share becomes. However, that should not be the only way you interpret a PE ratio. Because PE ratios take into account the share price and share prices incorporate investors' expectations of future performance, it is fair to say that PE ratio is also a measure of investors' expectations. A high PE means that investors expect much higher future profits, and conversely, a low PE means that investors do not expect the company to grow aggressively. So what is considered a high or low PE?

A PE ratio on its own does not mean much. It has to be compared to
(1) the market PE,
(2) the PE of companies in the same sector, and
(3) its historical PE range.
 

The Australian stockmarket long-term average PE is about 16-18. Goldman Sachs JBWere estimates the PE for ASX300 companies to be 14.8 for FY2005. So in comparison with the long-term average and the estimate for FY2005, Jumbuck's PE of 13.41 means that the stock is valued within the average range. This is only a rough guide.

The most useful comparison is to companies within the same sector. To find similar companies on the ASX, enter "Mobile" as the principal activity. A quick search reveals that there are no other ASX-listed companies developing wireless messaging and gaming applications for the consumer market. The closest is MGMWireless (MWR) which provides messaging systems for schools and businesses. MWR has not yet produced its first annual net profit.

We then looked for Jumbuck's global competitors using google search and found JAMDAT (JMDT) and InfoSpace (INSP). According to Reuters, JMDT's historical PE is 112.68 and INSP's is 6.31. The Software & Programming industry PE is 27.88. From first glance, Jumbuck's PE of 13.41 seems reasonable.

We must bear in mind, though, that the average PEs tend to be higher in US markets and peer companies tend to be much larger in terms of market capitalisation, so PE comparisons must be done with a pinch of salt.

PE ratio is often mentioned and quoted in the financial press and research, but it does cause flawed investment decisions if not understood and used properly. 

A better gauge to use is Earnings Yield. It is simply EPS divided by the share price. Think of earnings yield as the rate of return the company generates for its investors. You could compare earnings yield to return from alternative investments such as term deposit interest rates, government bond yields or the earnings yields of other stocks. According to Alan Kohler's article, the long-term average for Australian stockmarket is 6.7%.

Jumbuck's earnings yield is 7.46% (EPS of $0.0597 divided by share price $0.80). This is better than return from term deposits (around 5.6%) or Telstra (6.96%). So, another tick on the first cut.

From a fundamental analysis point of view, we can conclude that JMB is worth a closer look.
 

STAGE ANALYSIS - Stage analysis is a very straight-forward way of determining where the share price is in normal price cycle. Stan Weinstein explained very succinctly how stage analysis works.

JMB has clearly broken out of Stage 1 in May and is now in Stage 2 territory, as illustrated on the chart on the right.

As a general rule, the best place to enter a trade is on a breakout from Stage 1 to Stage 2. The second best place is within Stage 2, as early in Stage 2 as possible.

It is generally not wise to buy in Stage 3 and Stage 4, because the probabilities are working against you!

TREND - It is also clear that the medium-term uptrend (marked by blue trendline) is still holding.

I have seen beginners using all sort of technical indicators to determine whether a chart is in an uptrend or downtrend. This is not necessary. If you ask a 5 year-old whether the chart is going up or down, he or she will give you a straight-forward answer. That is all we need.

If you can draw a line connecting 2 (preferably 3) or more points, that is your trendline. Keep it simple.

Overall, the technical outlook is also acceptable for us to proceed to more detailed analysis.

On the first cut, the fundamental and technical evidence are both favourable.

5-Minute Break

If you have worked through the above exercise, give yourself a pat on the back!

You have done well!

Now that we have satisfied ourselves that JMB is worth a second look, we will dig a bit further.

From a fundamental analysis viewpoint, we are interested in:

• understanding the business model and its earnings growth potential
• analysing a handful of key profitability, efficiency, liquidity and solvency ratios
• studying brokers' profit forecasts, if available
• where possible, valuing the company's share using established methodologies such as discounted cashflow (DCF) method

From a technical analysis viewpoint, we want to study the chart in greater detail. Specifically, we want to:

• identify established support and resistance levels/zones
• understand the stock's price behaviour, e.g. in terms of liquidity (average volume traded) and volatility (trading range)
• identify if any chart patterns has formed on the chart
• establish how the share price is performing in relation to other competitor companies, as well as the market at large
• determine favourable buy points, stoploss and targets

EMOTIONS & DISCIPLINE - As investors, we are primarily trying to obtain the highest return possible from our investments. This means that we should always adopt an objective approach to analysing, buying and selling shares. There is a danger that you may get emotionally attached to a stock, especially after you have invested many hours analysing it. You should guard against this tendency! This is where discipline becomes very important!

TIMING - Whilst fundamental analysis is useful in determining the company's growth potential and investability, it is a poor investment timing tool as far as share investing is concerned. Technical analysis fills this void. While fundamental analysis tells you what to buy, technical analysis should be your primary tool in determining when to buy and sell.

BUSINESS MODEL & INDUSTRY DYNAMICS - Analysing a business is much simpler than many highly-paid analysts make it out to be. As private investors, we do not need to know the operational intricacies of the company we are analysing. We only want to know what drives REVENUE and what drives EXPENSES in a broad sense. That will give us an idea of the PROFIT drivers.

PROFIT  =  REVENUES  -  EXPENSES

Brainstorm - What drives Jumbuck's revenues
- the number of games and messaging applications it develops
- the quality and popularity of its products
- the number of telco carriers selling Jumbuck's products
- how proactive the telco carriers are in marketing Jumbuck's products
- the size of the target market (i.e. no. of mobile phone gamers & chatters)
- the price of games and messaging applications

Brainstorm - What drives Jumbuck's expenses
- the number of software developers it employs
- the amount of royalty fees it pays to licensors (e.g. to Viacom for Star Trek theme)
- the revenue sharing % with telco carriers
- Marketing activities

Understanding what the critical profit drivers are gives us an idea what to look out for to determine potential profit growth.

For example, we know that more people are buying and upgrading their mobile phones. This means that the consumer market for graphics-rich messaging applications and games is growing. According to AT Kearney research, 10% of the current 1.7 billion mobile phone users now download mobile games. Strategy Analytics estimates the mobile gaming market will grow 6 folds over the next 5 years.

Also, looking at the market projections and financial performance of other similar companies, we know that product demand is generally increasing at a rapid rate. So we can conclude that Jumbuck is in a high-growth industry, and therefore we could expect the company to grow revenue rapidly.

To generate a meaningful analysis, you could compare each of the factors with Jumbuck's competitors. For example, Jumbuck generates about A$7m annual revenue from 10 mobile games and 2 messaging applications, while Jamdat generates A$58.7m from 92 mobile games and other contents. From this simple comparison, we know that Jumbuck's product portfolio is very small but its average revenue per product is higher. To significantly increase its revenue, Jumbuck will need to introduce a lot more games and applications in the near future. One way is to partner with PC game developers to bring their existing games onto mobile phone platforms.

Jumbuck's business model is attractive. Product demand is global, steadily increasing and not dependent on economic cycle. Operating costs consist of mainly salaries and are largely fixed. This high operating leverage means that every revenue dollar above the breakeven point goes straight to profit. Further, because Jumbuck sells its applications directly through telco carriers instead of via a distributor/aggregator, it could maintain a higher profit margin. The telco carriers are also well-incentivised to sell Jumbuck's products because of the revenue-sharing arrangement.

In general, we can expect Jumbuck to continue growing its revenue rapidly as long as it continually improves its product development quality and momentum, and have more telco carriers selling its games and applications.
 

RATIO ANALYSIS

Profitability - Jumbuck's net profit margin has improved over the last year, from 30% to a projected 34-39%. Importantly, Earning Per Share (EPS) has more than doubled.

Liquidity - Current ratio has deteriorated somewhat but is still high at 4.11 times. This means that for every $1 of current liabilities, there are $4.11 of current assets. By any measure, this is a good figure.

Solvency - Jumbuck does not have any long-term debt. Excellent!

Efficiency - Because Jumbuck is not a manufacturing operation, it is not absolutely necessary to look at efficiency ratios.
 

From our ratio analysis, we can safely conclude that Jumbuck is a financially "safe" company. Another favourable piece of evidence.

PROFIT FORECASTS - JMB is not covered by any of the large brokers and as such no profit forecast is available. This is not surprising given that it is too small a company (by market cap) to even make it into the radar screen of major research houses. This in itself could be good news. You could think of JMB as a somewhat 'undiscovered gem'.

VALUATION - While valuation is a primary tool for professional investment analysts, private investors do not often have the time and expertise to properly value a security. A more efficient approach for private investors is to consult the forecast figures from analyst reports and calculate the Discounted Cash Flow valuation using those figures. In the case of Jumbuck, it is not currently covered by any analyst, so there is no reasonable basis for us to make a Discounted Cash Flow valuation.

From the analysis we have done so far, we are quite impressed with the company's fundamentals.

5-Minute Break

Congratulations! If you are still with us, you have had a good mental workout!

You are now a budding investment analyst!

SUPPORT & RESISTANCE - The major support and resistance levels are:
1. $0.25
2. $0.40
3. $0.55
4. $0.80

PRICE BEHAVIOUR - JMB is not a particularly liquid stock. We could run a 30-day moving average over the volume to find out the average trading volume. Investing in an illiquid stock carries a certain amount of risk, namely you may not be able to sell the desired amount when you want to.

CHART PATTERN - A symmetrical triangle has formed on the share price chart during the months of June and July. This is a neutral chart pattern. A breakout will occur when the share price rises above or below the right tip of the triangle. We will only buy when the share price breaks out above 85c. A valid breakout should always be accompanied by above-average volume.

COMPARATIVE PERFORMANCE - As mentioned earlier, there are no other ASX-listed companies operating in the same area. As such, we are unable to do a comparison of share price performance.

We shall now examine the chart for favourable buy points. Please refer to the chart illustrated above.

Favourable Buy Point 1 - A Stage 2 breakout is considered the most favourable point to enter a trade. A breakout from a base, marked by the yellow rectangle, signals a clear change in investors' sentiment. Buyers are overwhelming sellers and results in the share price moving out of its usual trading range. In JMB's case, we will buy when share price closes above 40c.

As a general rule, the longer the consolidation the further we can expect the share price to appreciate on breakout. JMB was in a consolidation phase for 9 months from Aug 2004 to Apr 2005. Some consolidations can take years.

Favourable Buy Point 2 - It is common to see a pullback a few days or weeks after a Stage 2 breakout. This is the "last" attempt by investors keen to sell to exit. After the pullback, we can expect the share price to continue heading north with little resistance. That is the case on JMB's chart in the month of May. We will take a position at the completion of a pullback and when share price rises above 40c.

Favourable Buy Point 3 - An ascending triangle has formed from around mid-May to mid-June. An ascending triangle is a bullish chart pattern. Breakout from an ascending triangle is a bullish signal. We will enter on a breakout when share price closes above 55c.

Favourable Buy Point 4 - From late June to early July, the share price has formed a downward channel (lower highs, lower lows). We will be interested in entering when share price closes above 75c (when downward channel has been broken), and adding to our position when it closes above the previous high at 80c.

Favourable Buy Point 5 - We are now at the hard right edge of the chart. As mentioned earlier, a symmetrical triangle has formed. We will enter or add if a breakout above 85c occurs.

STOPLOSS - As a general rule, we will always try to buy slightly above a support line, and set a stop just below support line. Setting a stoploss is not an exact science. It takes experience and practice to fine-tune your stoploss setting skill. Beginners have the tendency to set their stoploss too wide (i.e. lose a lot before being stopped out) or too narrow (i.e. get stopped out on small whipsaws and got out of the trade just when share price starts to move higher). It can be a very frustrating experience! Regardless, do not abandon your stoploss. Stoploss is a safety net that prevents you from making huge losses.

MONEY MANAGEMENT - The topic of money management is an important one. Whole chapters are written on the topic. We recommend these books for further reading: Better Trading: Money and Risk Management and Trade Your Way to Financial Freedom. Both books can be ordered through TNO's online store, http://www.investorshop.com.au.

In summary, we have reviewed both Jumbuck's fundamentals and chart, and came to a positive conclusion based on evidence we have collected.

We looked at Jumbuck's quarterly revenue trend and simple valuation metrics on the first cut. We also did a quick stage and trend analysis on the chart.

After satisfying ourselves that JMB was a potentially good investment, we investigated further. Our detailed analysis looked at Jumbuck's business model and key financial ratios, as well as investors' sentiment as illustrated on the chart.

The structured approach to analysing shares allows us to consider potential investments in an objective and comprehensive manner. It may seem like a lot of work at first, but you will become more proficient and efficient with practice. Given that your hard-earned money is at stake, the effort is necessary and well worth it!

Appendum: Following the publication of this tutorial, JMB has proceeded to break out from the symmetrical triangle we identified in Favourable Buy Point 5 and made new highs.

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