Fundamental analysis is the cornerstone of investing. In fact, some would say that you aren't really investing if you aren't performing fundamental analysis. Because the subject is so broad, however, it's tough to know where to start. There are an endless number of investment strategies that are very different from each other, yet almost all use the fundamentals.
The biggest part of fundamental analysis involves delving into the financial statements. Also known as quantitative analysis, this involves looking at revenue, expenses, assets, liabilities and all the other financial aspects of a company. Fundamental analysts look at this information to gain insight on a company's future performance.
But there is more than just number crunching when it comes to analyzing a company. This is where qualitative analysis comes in - the breakdown of all the intangible, difficult-to-measure aspects of a company
When talking about stocks, fundamental analysis is a technique that attempts to determine a security’s value by focusing on underlying factors that affect a company's actual business and its future prospects. On a broader scope, you can perform fundamental analysis on industries or the economy as a whole. The term simply refers to the analysis of the economic well-being of a financial entity as opposed to only its price movements.
Fundamental Analysis: Qualitative Factors - The Company: Even before an investor looks at a company's financial statements or does any research, one of the most important questions that should be asked is: What exactly does the company do? This is referred to as a company's business model – it's how a company makes money. You can get a good overview of a company's business model by checking out its website or reading the first part of its 10-K filing .
Sometimes business models are easy to understand. Take McDonalds, for instance, which sells hamburgers, fries, soft drinks, salads and whatever other new special they are promoting at the time. It's a simple model, easy enough for anybody to understand.
Other times, you'd be surprised how complicated it can get. Boston Chicken Inc. is a prime example of this. Back in the early '90s its stock was the darling of Wall Street. At one point the company's CEO bragged that they were the "first new fast-food restaurant to reach $1 billion in sales since 1969". The problem is, they didn't make money by selling chicken. Rather, they made their money from royalty fees and high-interest loans to franchisees. Boston Chicken was really nothing more than a big franchisor. On top of this, management was aggressive with how it recognized its revenue. As soon as it was revealed that all the franchisees were losing money, the house of cards collapsed and the company went bankrupt.
At the very least, you should understand the business model of any company you invest in. The "Oracle of Omaha", Warren Buffett, rarely invests in tech stocks because most of the time he doesn't understand them. This is not to say the technology sector is bad, but it's not Buffett's area of expertise; he doesn't feel comfortable investing in this area. Similarly, unless you understand a company's business model, you don't know what the drivers are for future growth, and you leave yourself vulnerable to being blindsided like shareholders of Boston Chicken were.
Fundamental Analysis: Qualitative Factors - The Company: Even before an investor looks at a company's financial statements or does any research, one of the most important questions that should be asked is: What exactly does the company do? This is referred to as a company's business model – it's how a company makes money. You can get a good overview of a company's business model by checking out its website or reading the first part of its 10-K filing .
Sometimes business models are easy to understand. Take McDonalds, for instance, which sells hamburgers, fries, soft drinks, salads and whatever other new special they are promoting at the time. It's a simple model, easy enough for anybody to understand.
Other times, you'd be surprised how complicated it can get. Boston Chicken Inc. is a prime example of this. Back in the early '90s its stock was the darling of Wall Street. At one point the company's CEO bragged that they were the "first new fast-food restaurant to reach $1 billion in sales since 1969". The problem is, they didn't make money by selling chicken. Rather, they made their money from royalty fees and high-interest loans to franchisees. Boston Chicken was really nothing more than a big franchisor. On top of this, management was aggressive with how it recognized its revenue. As soon as it was revealed that all the franchisees were losing money, the house of cards collapsed and the company went bankrupt.
At the very least, you should understand the business model of any company you invest in. The "Oracle of Omaha", Warren Buffett, rarely invests in tech stocks because most of the time he doesn't understand them. This is not to say the technology sector is bad, but it's not Buffett's area of expertise; he doesn't feel comfortable investing in this area. Similarly, unless you understand a company's business model, you don't know what the drivers are for future growth, and you leave yourself vulnerable to being blindsided like shareholders of Boston Chicken were.
Market Share-
Understanding a company's present market share can tell volumes about the company's business. The fact that a company possesses an 85% market share tells you that it is the largest player in its market by far. Furthermore, this could also suggest that the company possesses some sort of "economic moat," in other words, a competitive barrier serving to protect its current and future earnings, along with its market share. Market share is important because of economies of scale. When the firm is bigger than the rest of its rivals, it is in a better position to absorb the high fixed costs of a capital-intensive industry.
Industry Growth-
One way of examining a company's growth potential is to first examine whether the amount of customers in the overall market will grow. This is crucial because without new customers, a company has to steal market share in order to grow.
In some markets, there is zero or negative growth, a factor demanding careful consideration. For example, a manufacturing company dedicated solely to creating audio compact cassettes might have been very successful in the '70s, '80s and early '90s. However, that same company would probably have a rough time now due to the advent of newer technologies, such as CDs and MP3s. The current market for audio compact cassettes is only a fraction of what it was during the peak of its popularity.
Competition -
Simply looking at the number of competitors goes a long way in understanding the competitive landscape for a company. Industries that have limited barriers to entry and a large number of competing firms create a difficult operating environment for firms.
One of the biggest risks within a highly competitive industry is pricing power. This refers to the ability of a supplier to increase prices and pass those costs on to customers. Companies operating in industries with few alternatives have the ability to pass on costs to their customers. A great example of this is Wal-Mart. They are so dominant in the retailing business, that Wal-Mart practically sets the price for any of the suppliers wanting to do business with them. If you want to sell to Wal-Mart, you have little, if any, pricing power.
Regulation -
Certain industries are heavily regulated due to the importance or severity of the industry's products and/or services. As important as some of these regulations are to the public, they can drastically affect the attractiveness of a company for investment purposes.
In industries where one or two companies represent the entire industry for a region (such as utility companies), governments usually specify how much profit each company can make. In these instances, while there is the potential for sizable profits, they are limited due to regulation.
In other industries, regulation can play a less direct role in affecting industry pricing. For example, the drug industry is one of most regulated industries. And for good reason - no one wants an ineffective drug that causes deaths to reach the market. As a result, the U.S. Food and Drug Administration (FDA) requires that new drugs must pass a series of clinical trials before they can be sold and distributed to the general public. However, the consequence of all this testing is that it usually takes several years and millions of dollars before a drug is approved. Keep in mind that all these costs are above and beyond the millions that the drug company has spent on research and development.
All in all, investors should always be on the lookout for regulations that could potentially have a material impact upon a business' bottom line. Investors should keep these regulatory costs in mind as they assess the potential risks and rewards of investing.
Understanding a company's present market share can tell volumes about the company's business. The fact that a company possesses an 85% market share tells you that it is the largest player in its market by far. Furthermore, this could also suggest that the company possesses some sort of "economic moat," in other words, a competitive barrier serving to protect its current and future earnings, along with its market share. Market share is important because of economies of scale. When the firm is bigger than the rest of its rivals, it is in a better position to absorb the high fixed costs of a capital-intensive industry.
Industry Growth-
One way of examining a company's growth potential is to first examine whether the amount of customers in the overall market will grow. This is crucial because without new customers, a company has to steal market share in order to grow.
In some markets, there is zero or negative growth, a factor demanding careful consideration. For example, a manufacturing company dedicated solely to creating audio compact cassettes might have been very successful in the '70s, '80s and early '90s. However, that same company would probably have a rough time now due to the advent of newer technologies, such as CDs and MP3s. The current market for audio compact cassettes is only a fraction of what it was during the peak of its popularity.
Competition -
Simply looking at the number of competitors goes a long way in understanding the competitive landscape for a company. Industries that have limited barriers to entry and a large number of competing firms create a difficult operating environment for firms.
One of the biggest risks within a highly competitive industry is pricing power. This refers to the ability of a supplier to increase prices and pass those costs on to customers. Companies operating in industries with few alternatives have the ability to pass on costs to their customers. A great example of this is Wal-Mart. They are so dominant in the retailing business, that Wal-Mart practically sets the price for any of the suppliers wanting to do business with them. If you want to sell to Wal-Mart, you have little, if any, pricing power.
Regulation -
Certain industries are heavily regulated due to the importance or severity of the industry's products and/or services. As important as some of these regulations are to the public, they can drastically affect the attractiveness of a company for investment purposes.
In industries where one or two companies represent the entire industry for a region (such as utility companies), governments usually specify how much profit each company can make. In these instances, while there is the potential for sizable profits, they are limited due to regulation.
In other industries, regulation can play a less direct role in affecting industry pricing. For example, the drug industry is one of most regulated industries. And for good reason - no one wants an ineffective drug that causes deaths to reach the market. As a result, the U.S. Food and Drug Administration (FDA) requires that new drugs must pass a series of clinical trials before they can be sold and distributed to the general public. However, the consequence of all this testing is that it usually takes several years and millions of dollars before a drug is approved. Keep in mind that all these costs are above and beyond the millions that the drug company has spent on research and development.
All in all, investors should always be on the lookout for regulations that could potentially have a material impact upon a business' bottom line. Investors should keep these regulatory costs in mind as they assess the potential risks and rewards of investing.
Fundamental Analysis: Financial Statements - The Balance Sheet
The balance sheet represents a record of a company's assets, liabilities and equity at a particular point in time. The balance sheet is named by the fact that a business's financial structure balances in the following manner:
The balance sheet represents a record of a company's assets, liabilities and equity at a particular point in time. The balance sheet is named by the fact that a business's financial structure balances in the following manner:
Assets = Liabilities + Shareholders' Equity
Assets represent the resources that the business owns or controls at a given point in time. This includes items such as cash, inventory, machinery and buildings. The other side of the equation represents the total value of the financing the company has used to acquire those assets. Financing comes as a result of liabilities or equity. Liabilities represent debt (which of course must be paid back), while equity represents the total value of money that the owners have contributed to the business - including retained earnings, which is the profit made in previous years.
The Income Statement
While the balance sheet takes a snapshot approach in examining a business, the income statement measures a company's performance over a specific time frame. Technically, you could have a balance sheet for a month or even a day, but you'll only see public companies report quarterly and annually.
The income statement presents information about revenues, expenses and profit that was generated as a result of the business' operations for that period.
Statement of Cash Flows
The statement of cash flows represents a record of a business' cash inflows and outflows over a period of time. Typically, a statement of cash flows focuses on the following cash-related activities:
Assets represent the resources that the business owns or controls at a given point in time. This includes items such as cash, inventory, machinery and buildings. The other side of the equation represents the total value of the financing the company has used to acquire those assets. Financing comes as a result of liabilities or equity. Liabilities represent debt (which of course must be paid back), while equity represents the total value of money that the owners have contributed to the business - including retained earnings, which is the profit made in previous years.
The Income Statement
While the balance sheet takes a snapshot approach in examining a business, the income statement measures a company's performance over a specific time frame. Technically, you could have a balance sheet for a month or even a day, but you'll only see public companies report quarterly and annually.
The income statement presents information about revenues, expenses and profit that was generated as a result of the business' operations for that period.
Statement of Cash Flows
The statement of cash flows represents a record of a business' cash inflows and outflows over a period of time. Typically, a statement of cash flows focuses on the following cash-related activities:
· Operating Cash Flow (OCF): Cash generated from day-to-day business operations
· Cash from investing (CFI): Cash used for investing in assets, as well as the proceeds from the sale of other businesses, equipment or long-term assets
· Cash from financing (CFF): Cash paid or received from the issuing and borrowing of funds
The cash flow statement is important because it's very difficult for a business to manipulate its cash situation. There is plenty that aggressive accountants can do to manipulate earnings, but it's tough to fake cash in the bank. For this reason some investors use the cash flow statement as a more conservative measure of a company's performance.
10-K and 10-Q
Now that you have an understanding of what the three financial statements represent, let's discuss where an investor can go about finding them. In the United States, the Securities And Exchange Commission (SEC) requires all companies that are publicly traded on a major exchange to submit periodic filings detailing their financial activities, including the financial statements mentioned above.
Some other pieces of information that are also required are an auditor's report, management discussion and analysis (MD&A) and a relatively detailed description of the company's operations and prospects for the upcoming year.
All of this information can be found in the business' annual 10-K and quarterly 10-Q filings, which are released by the company's management and can be found on the internet or in physical form.
The 10-K is an annual filing that discloses a business's performance over the course of the fiscal year. In addition to finding a business's financial statements for the most recent year, investors also have access to the business's historical financial measures, along with information detailing the operations of the business. This includes a lot of information, such as the number of employees, biographies of upper management, risks, future plans for growth, etc.
Fundamental Analysis Valuation: The premise of the discounted cash flow method is that the current value of a company is simply the present value of its future cash flows that are attributable to shareholders. Its calculation is as follows:
10-K and 10-Q
Now that you have an understanding of what the three financial statements represent, let's discuss where an investor can go about finding them. In the United States, the Securities And Exchange Commission (SEC) requires all companies that are publicly traded on a major exchange to submit periodic filings detailing their financial activities, including the financial statements mentioned above.
Some other pieces of information that are also required are an auditor's report, management discussion and analysis (MD&A) and a relatively detailed description of the company's operations and prospects for the upcoming year.
All of this information can be found in the business' annual 10-K and quarterly 10-Q filings, which are released by the company's management and can be found on the internet or in physical form.
The 10-K is an annual filing that discloses a business's performance over the course of the fiscal year. In addition to finding a business's financial statements for the most recent year, investors also have access to the business's historical financial measures, along with information detailing the operations of the business. This includes a lot of information, such as the number of employees, biographies of upper management, risks, future plans for growth, etc.
Fundamental Analysis Valuation: The premise of the discounted cash flow method is that the current value of a company is simply the present value of its future cash flows that are attributable to shareholders. Its calculation is as follows:
·
For simplicity's sake, if we know that a company will generate $1 per share in cash flow for shareholders every year into the future; we can calculate what this type of cash flow is worth today. This value is then compared to the current value of the company to determine whether the company is a good investment, based on it being undervalued or overvalued.
Ratio Valuation : The calculations produced by the valuation ratios are used to gain some understanding of the company's value. The ratios are compared on an absolute basis, in which there are threshold values. For example, in price-to-book, companies trading below '1' are considered undervalued. Valuation ratios are also compared to the historical values of the ratio for the company, along with comparisons to competitors and the overall market itself.
Conclusion: Whenever you’re thinking of investing in a company it is vital that you understand what it does, its market and the industry in which it operates. You should never blindly invest in a company.
One of the most important areas for any investor to look at when researching a company is the financial statements. It is essential to understand the purpose of each part of these statements and how to interpret them.
One of the most important areas for any investor to look at when researching a company is the financial statements. It is essential to understand the purpose of each part of these statements and how to interpret them.
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