Fundamentals Analysis

by Dual Income No Kids on October 19, 2009 · 0 comments

The New York Stock exchange contains over 2,750 listings. NASDAQ has over 3,800. If you’re interested in investing in purchasing a share in an individual company, as opposed to a mutual fund or index fund, that’s a lot of stocks to sift through to find the handful of ones worth investing in. And that’s even ignoring the other major stock exchanges in the U.S. and abroad. So we’re presented with a problem: how are we to find, in the midst of all of these companies, the stocks that are going to perform how we want them to?

Ignoring the “but I have a good feeling about this one” approach (not a good one, in my experience by the way), we need to have a way of analytically evaluating companies. Doing so will hopefully eliminate companies that won’t give us what we want, and will identify red flags. We’re also looking for a way to better quantify our risk/reward ratio. The more we know, the better we’re (hopefully) off.

There are two main approaches that most people take when evaluating a stock: Fundamental Analysis and Technical Analysis. Technical Analysis is based on the principle that all relevant information regarding a security is reflected by the current price of that security. Technical Analysis ignores attempts to place a value on a stock; rather, trends are the main attraction.

Fundamental Analysis on the other hand is predicated on the idea that markets by nature misprice a certain subset of securities, but eventually the market will correct itself and a security will be offered at the correct price. Adhering to Fundamental Analysis principles means attempting to recognize undervalued companies and investing in them before the market corrects its mistake.

Finding bargain securities is more than just finding ones that are cheap. You have to analyze the current state of the economy, the current state of the industry within which the security you’re interested in is contained, and then finally, you have to analyze that company’s financial profile.

The above picture is from Google Finance’s page for Google. From it, you can see basic information about Google’s fundamentals, including the price per share, EPS, P/E and Volume, along with other popular indicators. It’s been my personal experience that Google Finance and Yahoo! Finance are the two best (free) sources of information on companies. If you’re looking to incorporate more Fundamental Analysis principles in your investing, here are some indicators to look for:

  • Assests

Assets are anything that has value or can be converted to or sold for cash. This includes investments, manufacturing equipment, copyrights and the like. When examining a company’s assets, you’re looking to see if they have increased their assets since the last year, and if they haven’t if it’s because they’ve written off an asset (like banks have done with these mortgage-backed securities) or sold a previously held asset.

  • Liabilities

Liabilities include anything that the company owes to another organization. This includes both long-term and short-term debt. A red flag when examining a company’s liabilities would be, for example, if the growth rate of a company’s liabilities is outpacing that of their assets. Recently, more companies have gotten to the point where they’re more willing to accept debt in exchange for potential growth. When the bottom fell out of the economy, these companies were left with crippling debt and stagnant asset growth. While it’s true that you have to spend money to make money, it has to be manageable. When I invest, the first thing I look at is a company’s total liability.

  • Equity

Equity is essentially the net worth of a company. It’s what’s left over when you subtract a company’s liabilities from their assets. What you’re looking for here is steady equity growth of 5-15%.

  • Sales

It’s pretty clear what sales are referring to, and obviously, sales are the lifeblood of a company, and a strong indicator of future growth. Again, you’re looking for a number here of around 10% increase in sales per year. Sharp increases in sales can garner a lot of attention, but probably aren’t sustainable, and single-digit increases don’t instill a lot of confidence in the future of a company, with regards to overall growth.

  • Earnings

Earnings are the bottom line; the buck stops at earnings when looking at a company’s income statement. Earnings can be sliced many different ways (Overall Earnings, Earnings from Operations, etc…) but at the end of the day, is the company increasing their earnings from year to year? An answer of “no” to that question is a strong indicator that you need to look elsewhere.

  • Expenses

Expenses can be thought of as the operating cost of running that specific company. What you’re looking for here is stability; expense growth that keeps reasonable pace with the growth of the company overall. Unusual expenses or spikes in expenses are red flags. If a company is too large and bloated, you’ll see huge expenses cutting into their profits (Profit = Sales – Expenses).

  • Price-to-Earnings Ratio (P/E)

I could write an entire blog post on P/E alone. P/E is one of the most widely regarded and used ratios in Fundamental Analysis. This ratio is important because it describes the relationship between the company’s earnings and the share price (The value can be found by dividing the current stock price by the EPS). But using P/E is all about context. That’s why it’s important to look at both the Trailing P/E (evaluated over the last 12 months) and the Forward P/E (evaluated using projections over the next 12 months). Low P/E’s are desirable, but again, it’s all about context. You need to compare a company’s P/E to both the industry and the general market, and then determine why the ratio is what it is. Is the P/E high because investors anticipate higher earnings in the future, or because earnings have plummeted? Is the P/E low because earnings have increased, or is the share price unreasonably inflated? If a company doesn’t have a P/E, that’s bad. That indicates that the company has no earnings, and outside of speculating (a.k.a gambling), it’s usually not a great idea to invest in a company with no earnings.

  • Price-to-Sales Ratio (PSR)

PSR is the company’s stock price divided by its sales. PSR doesn’t give the complete picture, but it can help grant more perspective on a company. Company’s are also notorious for manipulating their financials to cover up bad news, but sales are much harder to manipulate than earnings, which gives PSR some value. Generally speaking, a stock that has a PSR of less than one is considered a potential bargain.

  • Book Value

Book Value is a way of looking at a company from a purely accounting standpoint in an attempt to compare its market value to its intrinsic value. If a company has a market value that is more than its book value, that could indicate that the stock is overpriced, and should be avoided. Again, Book Value is a useful tool, but should just be considered part of the overall picture.

Of course, all of those indicators should be viewed in relation to both that company’s market sector and the overall economy. For example (purely hypothetical) if a company has, over the last 5 years, a yearly sales growth rate of 20%, that might look really good. But if the sector average is 30% per year, then that number doesn’t look so great. Also, like in these recent economic times, a company might only eek out a equity growth rate that’s barely in the black. But compared to the rest of the economy, that’s really good for right now.

Those are just some of the main indicators used; obviously there’s a ton of information, and countless other ratios and indicators used, such as Profitability, Return on Assets/Equity, Total Cash, PEG Ratio and others. If interested, there are a ton of books out there on fundamental analysis and even more free resources available online.

Twitter: @michael_DINK

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