An Introduction to Fundamental Analysis
Introduction to Fundamental Analysis
What is Fundamental Analysis
The basis of fundamental analysis is to determine the financial stability and the future profitability of companies, and therefore their future worth, which is extremely important as this future worth determines their future share price.
To put this simply, a company with its sales revenue and profits increasing will be worth more than a company with declining sales revenue and profits.
Financial reports are provided by companies, typically on a quarterly basis together with one final annual report.
These financial reports are accounting statements which provide a means of tracking how much money a company is making and how much it is spending.
Stock market Analysts use these financial reports to forecast future sales revenue and profits.
While an individual stock investor can go through the financial reports themselves, generally it is quicker and simpler to use summarized data that is readily available from information websites.
These websites also usually provide forecast sales and profit data as well.
Analyzing the Past and Future
Fundamental analysis looks at both the past and the future.
The past sales and profit data is used to determine how reliable and consistent a company is, while the forecast sales and profit data is used to determine the company's future growth potential and hence the potential future share price gain.
This financial data allows an investor to make an informed decision regarding the future business value of a company and thus it's investing potential.
The source of fundamental analysis
Companies reporting their Financial Activities
Companies report their financial activities by lodging a financial report to the SEC (Securities and Exchange Commission).
These reports are typically lodged every quarter for the first three quarters and then for the fourth quarter they lodge a final report that covers the entire fiscal year's financial activities.
The quarterly reports are known as "10-Q filings" and the annual report is known as a "10-K filing".
These reports are known as financial statements and are readily available in a summarized format through various websites.
While the stock investor does not necessarily need to go through these reports, it is extremely beneficial to at least understand the key components that are contained within these reports.
These financial reports contain three major sections which are the income statement, Balance sheet statement and the Cash Flow statement.
The income statement has three main components:
- Revenue: How much money the company received from selling its products or services. This is known as revenue, which is often referred to as sales.
- Expenses: How much money the company spent to achieve this revenue. This is known as expenses and they include the cost of purchasing and/or producing the products that were sold, their administration costs such as salaries and office supplies, interest payments on loans, any rent and utility bills, and the depreciation costs of equipment and buildings.
- Net Profit: The bottom line profit made, which is simply how much money is left over after all the expenses are paid for and the tax liability is deducted. Net profit is commonly referred to as earnings.
The first thing the income statement shows is whether or not the company made a profit.
When comparing to previous fiscal years, the stock investor can readily determine whether or not the company has been profitable over the years, and whether the company's revenue and net profit have been increasing or decreasing.
The income statement used to be called the profit and loss statement.
Balance Sheet Statement
The balance sheet statement has three main components:
- Assets: This is the total value of everything the company owns. It includes cash in the bank, office equipment, plant and machinery, stocked products waiting to be sold and any money to be received from products sold or services provided.
- Liabilities: This is the total of all borrowed money the company owes. It includes loans from banks, money obtained from issuing bonds and any unpaid bills.
- Equity: How much money the company would have if it sold all its assets and paid back all the money it owes. Equity is often referred to as net assets and is also known as shareholder equity.
The balance sheet shows what the company owns and what it owes at the time of reporting and this can vary from one report to the next.
Stock investors can readily see how much cash the company has as this cash is what pays the company's bills.
Without adequate cash reserves, the company will need to borrow more money, thus reducing stockholder equity which is obviously undesirable.
Cash Flow Statement
The cash flow statement has three main components:
- Operating activities: This shows all the money the company received from selling its products and/or services and it shows all the money that was directly spent to sell its products and/or services. Excluded is money spent on purchasing new equipment, machinery or on any large scale purchases such as buying other business.
- Investing activities: Any large scale purchases such as new equipment, machinery or buying other business are included here. These large scale purchases are referred to as capital expenditures.
- Financing activities: Includes any money borrowed by the company or any loan repayments made. Also included are any share repurchases and any dividend payments made.
The cash flow statement shows the actual cash the company received and the actual cash that was paid out of its bank account.
At first this may appear to be the same as the income statement; however the income statement shows the profit made for tax reporting purposes, it does not show the actual cash flow as it includes non cash items such as deprecation and it excludes capital expenditure. In other words, a company may show a profit on the income statement but have insufficient cash to pay its bills or pay any dividends.
Financial Terms and Ratios
The essence of fundamental analysis
The most commonly used terms and financial ratios used in fundamental analysis are listed below.
While there are numerous terms and ratios not listed here, the ones listed are the most important and they tend to be the easier ones for beginner stock investors to understand.
Key Terms used
There are some key terms used in fundamental analysis that are taken from the financial statements and they are summarized as followers:
Revenue: The money a company receives from its sales or from providing a service.
Expenses: This is what it costs the company to obtain its revenue.
Net Profit: The money the company actually made. It is simple the money that's left after the expenses are paid.
Total Assets: The total value of every thing a company owns.
Total Liability: The total value of all borrowed money and any unpaid bills.
Net Assets: Also referred to as stockholder equity and is the value of what the company owns outright. It is simply the value of its total assets after all its total liabilities have been repaid.
EPS: This is simply the company's net profit divided by the number of shares outstanding. It is each shares portion of the company's profit and is referred to as earnings per Share.
forecast EPS: This is an estimated EPS for the next 12 months as determined by financial analysts. Some analysts provide EPS forecasts for the next 2 years or more.
Book Value: The net assets divided by the number of shares outstanding.
Key Ratios used
Fundamental analysis uses a series of simple ratio calculations to help determine the financial soundness of a company. These ratios utilize data from the financial statements and are summarized as follows:
EPS growth rate: This is the difference between the EPS and the forecast EPS, this figure is then divided by EPS and then multiplied by 100 so that the result is expressed as a percentage.
Example: A company with an annual EPS of $5 and a forecast EPS of $6 gives
EPS growth rate = ( 6 - 5 ) / 5 * 100 = 20%
PE ratio: This stands for price earnings ratio and is the stock price divided by the earnings per share.
Example: A company with an annual EPS of $5 and a stock price of $80 gives
PE ratio = 80 / 5 = 16
PEG ratio: This stands for price earnings growth ratio and is the PE ratio divided by EPS growth rate.
Example: A company with an PE ratio of 16 and a EPS growth rate of 20% gives
PEG ratio = 16 / 20 = 0.8
Dividend yield: This is the dividend amount per share divided by the stock price and is expressed as a percentage.
Example: A company with an annual Dividend payment of $2 and a stock price of $80 gives
Dividend yield = 2 / 80 * 100 = 2.5%
Price to Book ratio: This is the stock price divided by the book value.
Example: A company with a book value of $20 and a stock price of $80 gives
Price to Book ratio = 80 / 20 = 4
These terms and ratios form the basis for fundamental analysis and are used in all investing strategies.
Basic valuation techniques that beginner investors find easy to use
Stock Valuation Methods
All stock valuation methods are only of any use if the company is fundamentally sound, which is the first thing that needs to be determined.
Once it's been determined that a company is fundamentally sound, there are several approaches which give a general idea of its valuation.
Some valuation methods are very simple to use while others involve extensive complex calculations such as the discounted cash flow method.
Irrespective of the method used, they all aim to provide a fundamental valuation for the business operations of the company.
Some valuation methods provide an absolute value and others provide a relative valuation that needs to be compared to similar companies.
Some of the simplest valuation methods that stock investors can use are as follows:
This is an extremely popular valuation method which works quite well for companies that have a relatively stable history of making a profit, but the PE ratio does have a number of disadvantages.
One disadvantage is that if the profit reported is negative (that is a loss reported rather than a profit), the PE ratio becomes negative which is meaningless.
Another disadvantage is that if a company reported an abnormally high or low profit, the PE ratio will be abnormally low or high, again making it a meaningless figure.
One more issue with the PE ratio is that it is only really useful as a relative valuation; it does not provide an absolute valuation.
Relative valuation simply means that the PE ratio must be compared to the PE ratio of similar companies, which is known as industry ratio analysis.
The PE ratio can be calculated using different types of earnings. The earnings can be either the last reported annual net profit or an analyst forecast annual profit.
When using reported profit figures, the last annual figure can be used or alternatively the last four quarterly profit figures can be added together and used in the PE calculation.
This can be beneficial if there is has been six months or more since the last annual report.
Example: A company with an annual EPS of $5 and a stock price of $90 gives:
trailing PE ratio = 90 / 5 = 15
Generally the term trailing is omitted when using reported data and it's simply called PE ratio or even just PE. To distinguish that forecast analyst estimates are used, the term forecast is normally placed in front so it reads forecast PE ratio.
Example: A company with forecast EPS of $3 and a stock price of $45 gives:
forecast PE ratio = 45 / 3 = 15
The PE ratio on its own does not provide a valuation, but needs to be compared to the PE ratios of similar companies in order to determine whether it is cheap or expensive.
This is the PE ratio taken one step further by including the forecast annual growth in profits into the calculation, but still has the same disadvantages that the PE ratio has.
While the PEG ratio gives some insight into the growth potential of a company, it does rely on a forecast EPS which may or may not be achieved.
Example: A company with annual reported EPS of $2.50 and forecast EPS of $3 with a share price of $45.
trailing PE ratio = 45 / 2.5 = 18
EPS growth rate = (3 - 2.50) / 2.50 * 100 = 20%
PEG ratio = 18 / 20 = 0.9
While the PEG ratio is a relative valuation, it is generally accepted that a stock is undervalued if its PEG ratio is less than one and that it is overvalued if more than one.
Price to Book ratio
This is a popular valuation method which works quite well for companies that have a history of making a profit.
This is a very conservative method that will generally undervalue a company for most of the time, as it does not take into account the profitability of the company.
However, when stock prices fall and the company remains fundamentally sound, this method provides a convenient way of buying stock at very cheap prices.
This approach works best with companies which have a lot of tangible assets.
Example: A company with Net Assets of $10,000,000 and 1,000,000 shares outstanding with a stock price of $15.
Book value = 10,000,000 / 1,000,000 = $10 per share
Price to Book ratio = 15 / 10 = 1.5
Generally a stock is considered undervalued if the Price to Book ratio is less than one, however it must be stressed that the company must be fundamentally sound, otherwise there is a high probability that the net assets will decline over time.
The price to book ratio is an absolute valuation method that uses the company's net assets for its valuation and therefore does not need to be compared to other companies.
Investors who understand economics are prepared for adverse market conditions
Economic Terms and Phrases
There are numerous economic terms and phrases that are frequently mentioned by the financial press such as booming economy, economy grew by 2%, expanding economy, inflation is up 1%, deflation, recession and shrinking economy.
But what does all this mean to the stock investor and is any of it even important to understand?
Getting a grasp on basic economics allows the stock investor to understand the relationship between the valuation of stocks and the state of the economy.
The state of the economy is important to investors as it determines whether stock prices will broadly increase or decline.
Supply and Demand
To keep it really simple, economics is basically the study of supply and demand between businesses and consumers.
To illustrate this concept - when the number of consumers who are willing to pay for a product or service increases, they increase the demand and businesses can respond to this increased demand by supplying more products or supplying more services, and in doing so businesses typically need to employ additional staff which has the added benefit of reducing unemployment.
Conversely, if demand from consumers declines, businesses respond by supplying less products or services and therefore require less staff, which has the undesirable effect of increasing unemployment.
This supply and demand is effectively monitored by an economic measure known as GDP, which stands for Gross Domestic Product and is an important economic measure of the financial health of a countries economy.
GDP is simply the total value of products sold and services provided by a range of businesses. Other important economic measures are CPI and PPI.
The Consumer Price Index (CPI) is a commonly used measure of inflation that tracks the changes in prices experienced by consumers.
Another measure of inflation is the Producer Price Index (PPI) which tracks the changes in prices experienced by businesses.
Expansion and Contraction Phases
Economies go through phases of expansion and contraction, which are known as Business Cycles and are measured and tracked using the GDP.
The financial press will generally refer to the expansion phase with terms such as booming economy, economy growing and expanding economy.
With a contracting economy, the popular financial press terms used are recession and shrinking economy.
Investors should be aware that the economy goes though
business cycles of expansion and contraction
During the expansion phase the GDP increases and unemployment declines, and inflation also tends to increase. Conversely, during the contraction phase the GDP declines, unemployment increases and inflation tends to decline.
The contraction phase has averaged around three quarters since 1950 and is generally much shorter than the expansion phase which can be quite long and can be in the order of a decade or more.
In an expanding economy, the GDP continues to increase which simply means that the products and services provided by these companies is increasing, which means that their revenue is increasing and this means that their profits are increasing.
For the stock investor, this increases the value of these companies which has the positive affect of increasing their share prices.
This provides an important relationship between the phase of the economy and the phase of the stock market.
An expanding US economy leads to a Bull Market for stocks and a contracting economy leads to a bear market for stocks. The stock market cycles tend to follow the business cycles.
The astute stock investor will note that reference was made to the 1950s, but what about the great depression of the 1930s?
Modern economics is largely controlled by government influences through policies and through the Federal Reserve Bank with their monetary control.
In the earlier days, supply and demand was uncontrolled, and this lead to excessive economic expansions such as that during the 1920s, which in turn lead to excessive economic contractions such as the 1930s great depression.
Nowadays, the Federal Reserve Bank provides a fair amount of control by adjusting the Fed interest rate (the interest the Fed Reserve charges banks to borrow money from them).
Basically, the more banks pay for money, the more they charge consumers who borrow money, thus affecting how much money consumers can spend on products and services.
In the long term, the economy spends considerably more time expanding than it does contracting, which in part is due to policy and monetary control.
This means that the GDP increases over the long term, thus company revenues increase over the long-term and therefore stock prices increase over the long-term.