Fundamental Analysis: An Investor's Guide

 

What is fundamental analysis?

Fundamental analysis is the foundation of solid investing. It helps you determine the underlying health of a company by examining the business’ core numbers: its income statements, its earnings releases, its balance sheet, and other indicators of economic health. From these “fundamentals” investors evaluate if a stock is under- or overvalued.

Fundamental analysis begins with an individual stock, but it also extends to that company’s larger context. It explores questions like these: Is the company competitive within its industry? Is that industry growing or shrinking, compared to other sectors?
Shares of companies with strong fundamentals will tend to go up over time, while fundamentally weak companies will see their stock prices fall. This makes fundamental analysis especially valuable to long-term investors.

Fundamental analysis is one school of investing research. It contrasts with another popular approach, technical analysis, which focuses not on business fundamentals but on stock-price action as reflected in charts. Technical analysts look for recognizable patterns in price charts that will help them estimate the stock’s future price movement.

Why conduct fundamental analysis?

Fundamental analysis helps you determine if a company is a good or poor investment choice. Imagine you’re a venture capitalist or a bank, who must decide if that company is worthy of a loan or equity investment. How can you evaluate whether this particular company deserves your investable capital?
Fundamental analysts consider the following in making their decision to invest (or not):

• Is the company making a profit consistently? (While this is naturally the most important question for investors, it’s important to consider the answer in a bigger context. A single profitable quarter for a new company might be a fluke. In the same regard, a drop in profitability for an established blue-chip company might just be a temporary setback.)
• Is that profit growing or declining over time?
• Is the company holding its own relative to the competition? Is it a leader in its sector? Is that sector growing or declining in importance to the overall economy?
• Can the company pay its bills adequately? If you were to dismantle the company’s operations today, what would be the intrinsic value of its assets versus the value of its debts?

What information do you need to perform fundamental analysis?

You can think of fundamental analysis as “investing by the numbers,” since much of the work involves evaluating financial statements issued by the company. Here are a few key statements you should learn to read and understand.
All publicly traded companies in the United States are required to file statements of financial condition on a regular basis. These include the 10-Q, a quarterly statement, and the 10-K, an annual statement.

Each statement follows a prescribed form to include certain basic information.
Publicly traded companies are also subject to audits by government agencies that oversee their given industry. Those audits may be either scheduled or random events. The results of a regulatory audit may also be published--interesting reading for a would-be investor.
The 10-Q and 10-K are good places to start your fundamental research, but you’ll likely want to dig deeper into the specifics. For that you’ll need to understand three interrelated types of statements: the balance sheet, the income statement and the cash flow statement.

Reading a balance sheet: Assets

As the name suggests, a “balance sheet” presents a picture of how the company’s assets – the value a company takes in – are “balanced out” against its liabilities – what the company must pay out. When Assets equals Liabilities plus Equity, that’s when the statement is said to be in balance.
In most cases, balance sheets are presented in left and right side format. You'll find Assets on the left, and on the right side of the page are the Liabilities and Equity. (Sometimes these items are listed from top to bottom instead of left to right.)

Assets include resources the company has that are worth something. Many of these are self-explanatory, like Cash & Investments. Others are less familiar, like Current Assets, which refers to the value of assets that are readily converted into cash, such as Inventory or Receivables.
Longer-term assets vary depending on business type, but may include such things as property or equipment values. Since long-term assets gradually decrease in value over time, Accumulated Depreciation is subtracted from this. Note that depreciated assets may show up as having little or no value on the balance sheet but may have a much greater market value if sold.

Reading a balance sheet: Liabilities

Liabilities are obligations the company has made to outside parties who have provided resources. In essence, these outside parties may have lent money or other supplies to the company and therefore are owed repayment. It’s important to note these outside parties do not have ownership in the company; they are creditors.

Items under Liabilities include Accounts Payable, the amount the company may owe suppliers, and Income Taxes Payable, which is self-explanatory. Note that Current Liabilities, which are short-term, are listed separately just as Current Assets are. This section may also contain long-term debt obligations: for example, if the company has taken out bank loans to finance equipment or real estate, or if the company has issued corporate bonds to investors.

A figure called the Quick Ratio helps investors determine if a company’s assets and liabilities are in a healthy balance. The quick ratio measures a company's ability to meet its short-term obligations with its most liquid assets. The higher the quick ratio, the better the financial position of the company. It’s calculated as follows:



Note that the Quick Ratio is more conservative than some other liquidity measures, like the Current Ratio, because it excludes inventory from current assets. If you believe the company might have difficulty turning their inventory into cash, then the Quick Ratio might give a more accurate picture of the company’s short-term financial strength.

Reading a balance sheet: Equity

In a fundamentally healthy company Assets will outweigh the Liabilities. The difference between the two is called Equity. Again, a balance sheet “balances” when Assets equals Liabilities plus Equity (A=L+E).
This brings us to the bottom section of the balance sheet: Shareholders’ Equity. Equity is capital obtained from sources other than creditors. What are these sources? Paid in Capital refers to money investors paid the company for the stock during the initial public offering in order to become shareholders. Paid in Capital also includes capital raised from any subsequent offerings or sale of new stock. Keep in mind this does equal not the current price of the stock.

However, this does not make the two sides balance. This brings us to the concept of Retained Earnings. Mathematically speaking, this is the amount that makes the balance sheet’s two sides even. Put another way, Retained Earnings refers to the income that’s been kept (retained) by the company. It’s not a pile of cash sitting somewhere; rather it’s the amount of money that “belongs to the shareholders”, the value the company has generated beyond paid in capital and assets that exceed liabilities. Investors generally like to see Retained Earnings growing over time.


A company’s balance sheet gives us a high-level picture of a business, but by itself it tells us only so much. Balance sheets always balance Assets with Liabilities and Shareholders’ Equity. It takes delving into income and cash-flow statements to learn more about the health of the company and whether growth is trending upwards or downwards over time.

Reading an income statement: Revenues and Costs

The income statement gives a more detailed answer to a critical question for any investor: is the company making money? The well-known expression “the bottom line” comes from income statements. Specifically, it refers to a company’s Net Income. While this is obviously an important figure, it’s worth reviewing an income statement line-by-line. There may be little bits of good news or red flags revealed along the way to calculating that final figure.

The income statement starts with Net Sales or Revenues, the so-called “top line”. When analysts refer to “top-line growth”, what they really mean is: Are total revenues growing or shrinking? This is important because if the top line isn’t growing, where will sustainable growth come from?
The next two lines cover what it cost the company to produce the products and services sold. Cost of Goods Sold covers direct costs of materials, labor, et cetera. Depreciation, Depletion & Amortization is an indirect cost associated with production. For our purposes we’ll lump them together.

Another line item of cost is Selling, General & Administration Expenses. These costs pertain to operating the company and promoting the product. Analysts watch the so-called “SG&A” costs closely. Problems often show up here before they are apparent in the bottom line.

Reading an income statement: Margins and Earnings

Gross Income is calculated by subtracting costs from revenues. Gross Income plays an important role in calculating Gross Margin. This ratio measures what percentage of revenue is profit after we remove the costs associated with producing it.
For example, if Drite Rite Motors had $100 million in gross revenues and $70 million in costs, gross margin would be 70/100=0.7. In other words, the company’s cost to produce $100 million in revenue is 70% of that revenue. Gross Margin refers to the percentage of that amount that’s profit, the remaining 30%.
Is a 30% gross margin good? We’d need to compare this company’s gross margin with its competitors to benchmark this particular industry. It’s also smart to consider whether a company’s gross margins are going up or down over time.

Operating Income is calculated by subtracting Selling, General & Administration Expenses (SG&A) from Gross Income. Financial analysts pay close attention to Operating Margin, which is operating income as a percentage of revenue. They’re also interested in Profit Margin (as no doubt you are), which is net income expressed as a percentage of total revenue.

Reading an income statement: Earning Ratios

You’ll hear investors discussing three earnings-based ratios a lot: EPS, P/E and PEG.
Earnings Per Share (EPS) – this refers to the total amount a company earned in a given timeframe, divided by the number of outstanding shares. EPS is one of the most-quoted indications of a company’s current health.

Price-to-Earnings Ratio (P/E). Since you’re buying a share of the company to get a share of their earnings, you should want to know how much you’re paying for that privilege. P/E can be a handy yardstick for whether you’re paying dearly to tap a company’s earnings stream, or whether you’re getting a bargain.
P/E is calculated as follows: you take the price of the stock and divide it by the EPS. P/E is always quoted using annual earnings.

What should P/E be? Again, numbers like these are relative to the company’s sector and current market conditions. You should compare your company’s P/E to that of its chief competitors, and then check out the average P/E for the S&P 500.
Price/Earnings-to-Growth (PEG). When you start comparing the P/E ratios of various stocks, you may find it confusing. XYZ has a P/E of 59; ABC has a P/E of 12. Does that mean XYZ stock is over-priced and ABC’s is a bargain? Maybe. Why doesn't the market establish what the P/E ratio “should” be and adjust all stock prices accordingly?

The short answer is that earnings change, and individual stock prices are determined by the expectation of future earnings. By contrast, P/E and EPS give us only a snapshot in the past. Another problem is in the way companies report earnings and the way in which the market interprets them. If a company has a "one-time charge against earnings" for some extraordinary reason, this lowers EPS. However, the market may focus more on what earnings would have been if the one-time charge were ignored.

So how should we compare these numbers? Enter PEG, an earnings ratio that tries to account for future growth. It’s calculated by taking the P/E ratio and dividing it by the annual EPS growth rate. PEG is a widely used measure of valuation. A PEG of one suggests the stock is fairly valued. If it’s greater than one, the stock may be over-priced. If less than one, the stock may be undervalued. PEG is useful in evaluating high-growth stocks, because even though their current earnings may be modest, the expectation is that these companies are poised for potentially explosive growth.

Reading a cash flow statement: The Big Picture

The cash flow statement helps investors answer questions like: Is the company generating enough cash needed to fund growth? Is growth outpacing cash generation, requiring additional financing? Is the company generating enough cash to cover its short-term needs?
In times of easy credit, companies may be able to patch over cash flow interruptions with interim financing; during tighter credit markets, though, such financing may not be as readily available. In those situations, steady cash-flow generated by the company’s operations becomes especially important.

There are three big categories of cash flow to pay attention to here. Word of warning: it’s not always crystal-clear from just glancing at a cash flow statement which line items represent cash flowing IN versus cash flowing OUT. Cash generated by and used by the company’s operations is summarized in the Net Cash Flow – Operating Activities line. That line includes cash flowing in as well as cash-out.
The company’s long-term investing of cash is detailed in the Net Cash Flow – Investing line. That consists of cash flowing out. The third and last part, the “Net Cash Flow – Financing” line, shows the cash a company raised through from financing activities. That’s cash that came in.

The very bottom line shows the net change in the company’s cash position. If you add the line to the cash on the balance sheet from the previous year, you’ll get the current cash position on the current year’s balance sheet.

Reading a cash flow statement: Operating Cash Flows

That’s the top level of categories, so let’s dig into the specifics a bit. The cash flow statement starts with Net Income, a figure which comes from the income statement. You’ll notice next Depreciation, Depletion & Amortization is added back in. These costs impact the company’s profitability but aren’t, literally speaking, cash flows out of the company. You could safely call these paper losses.

Depreciation is deducted when determining a company’s net profit, because it’s assumed that the things being depreciated have lost value. The rest of the top of the statement provides a more detailed explanation as to where cash came from and was used in operations.

Things like a change in Accounts Payable and Inventory can change the company’s cash position. For example, this line item would include things like bills the company hasn’t yet paid – that’s cash the company still technically has on hand. Another item you might note in this section is increases in inventory, which costs the company some cash. The subtotal for Net Cash Flow – Operating Activities will usually be a positive figure, indicating cash flowing in.

Reading a Cash Flow Statement: Investing and Financing Cash Flows

If the company takes on new fixed assets like equipment or additional plants, that’s an example of investing-based cash flows. The investing section of a cash flow statement may also include new assets acquired during a merger, disposal of fixed assets that were previously on the books, and other items. The Net Cash Flow – Investing line will be either positive or negative, indicating whether net cash flowed out or in due to investing activities.

When we talk about cash flows from financing, keep in mind that “financing” might mean cash is coming in, if the company takes on new debt, or flowing out, if they choose to pay down debts. The financing section of the statement may also include cash dividends paid out to common or preferred stockholders, purchases or conversions of the company buying its own stock on the open market, the effects of foreign currency fluctuations and other items. Again, the Net Cash Flow – Financing line is either a positive or negative number, telling you whether net cash flowed out or in due to financing.

A cash flow statement may feel like a dry record of cash shunting from the plus to the minus columns and back again. It’s only in closer inspection and comparison of statements over time that interesting discrepancies can reveal themselves. For example, say while comparing cash flow statements for a company over several years, you notice a sizeable jump in a company’s Receivables item. This may simply be an accounting change and not mean much in real terms. However, if that’s not the case, a jump in Accounts Receivables might mean the company is having a harder time collecting from its customers – an important shift that the company will naturally not seek to advertise. It’s nuggets like these that reward the patient work of an investor willing to dig through financial statements to find potential red flags or opportunities unseen by the less-observant eye.

(See more)  Technical Analysis: A Trader's Guide

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