We often talk about the critical importance of combining both technical and fundamental analysis into a cohesive whole when making investing decisions.
Both of these seemingly contradictory analysis techniques have dramatic flaws. The secret to success in the stock market is the combination of these two analysis methods.
Charting and price analysis was once relegated to the investment underground with only the hardest core analysts charting price by hand. The majority of investors used fundamental analysis to make decisions.
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Things have changed radically over the last several decades. The power of the internet and PC’s have made technical analysis the de facto analysis technique.
Today, many investors do not understand how to conduct fundamental analysis. This article will make fundamental analysis easy to use by breaking it down into its most critical components
The number one most critical thing to understand when conducting fundamental analysis is profitability. Every company needs to be profitable to survive. The best way to determine profitability is by profitability ratios.
Profitability ratios measure a company’s financial performance and its capacity to boost its shareholders value and create profits. Profitability ratios provide insight into the profits made by the company in relation to its size, assets, and sales and also measure the company’s performance in relation to itself. Using past data as a benchmark, the investor can start to make a hypothesis as to why profitability is increasing or decreasing. Then based on this hypothesis, a reasoned decision can be made if the share price is under or overvalued, is the company profitable, and how it ranks on the profit making scale compared to its peers in the same sector.
The most popular profitability ratio is called RETURN ON EQUITY.
The term Return on Equity, or ROE, measures the amount of profit that a company generates through the use of shareholders’ equity. Before you get afraid that the Return on Equity or ROW ratio requires heavy math, let me assure you that it is very easy to calculate.
ROE is determined by dividing net income by average common shareholder’s equity. The reason we use an average here is due to the fact that common outstanding shares can fluctuate in size throughout the year. Companies may bring additional shares to the market or actually buy them back depending on their cash needs and expectations for the future.
Just in case you don’t know, share holder equity is a company’s total assets minus its total liabilities. Equally, it is share capital plus retained earnings minus treasury shares. Shareholders’ equity represents the amount by which a company is financed through common and preferred shares.
Investors understand that a company with a higher ROE is a better investment than one with a lower ROE since it has a stronger ability to generate cash; however, this is not completely accurate. Some firms which have lower asset requirements may have sky high ROE but the risk of them continuing to maintain that ROE is not very high as the market for their offering will invite many competitors. Conversely, there are many industries that rely heavily on heavy capital spending to launch the business; transportation and oil companies are prime examples of this idea. These firms will have less competition due to the high start up costs. The key takeaway from this is to understand the sector that you considering investing in and comparing similar companies rather than trying to compare diverse companies in different sectors.
As in all math based formulas, an illustration speaks a thousand words.
ROE broken down to its simplest format:
Now that we understand the critical importance of profitability when conducting fundamental analysis on a company, let’s dig a little deeper into the overall financial health of a company. Remember, just because a company is showing strong profitability, it in and of itself, is not enough to make a wise investment or even trading decision.
The first step in determining the financial health of a company is to understand the financial statements. Corporate financial statements may seem daunting at first. However, they are truly simple. Let me explain.
There are four primary financial statements. These statements are: (1) balance sheets; (2) income statements; (3) cash flow statements; and (4) statements of shareholders’ equity.
Here’s an easy to understand review and example of each type of financial statement that will reveal the overall financial health of the company.
- Balance Sheet
A balance sheet does exactly what its name describes. It shows the balance of a company’s assets, liabilities and shareholder equity.
Here’s a closer look at what makes up a balance sheet.
Assets are everything the company owns that has value. In most cases this means they can either be sold or used by the company to make products or provide services that can be sold. Assets include physical property, such as inventory, equipment, trucks, offices, plants, real estate. It also includes intangibles, such as trademarks and patents. Finally, cash itself is an asset.
Liabilities are the company’s debt. This includes all obligations, not just traditional debt. Things like money borrowed, rent, money owed for any number of reasons, salaries the company owes to its employees, environmental remediation costs, or taxes owed to governmental entities. Remember, liabilities can also include promises to provide goods and services to customers in the future.
- Income Statement
Income statements are an account that reveals how much revenue a company earned over a specific time period. This time period can be a quarter or annually. In addition, an income statement includes the costs and expenses used to earn the revenue. The bottom line of the statement is where you find the company’s actual earnings and losses over the period. The strongest fundamental companies will show an steady increase in earnings over time.
At the same time income statements detail earnings per share (or “EPS”). This calculation tells you how much money shareholders would receive if the company decided to distribute all of the net earnings for the period. To calculate EPS, take the total net income and divide it by the number of outstanding shares of the company.
- Cash Flow Statements
Cash flow statements identify the company’s movement of cash. Cash is the lifeblood of companies regardless of size. Cash flow statements show whether or not the company generated cash and how much cash was spent.
Unlike balance sheets that only show a snapshot in time, cash flow statements indicate changes over time rather than total dollar amounts at a single point. The data is gleaned from a company’s balance sheet and income statement.
Stated simply, the cash flow statement reveals the net increase or decrease in cash for the period. Usually, cash flow statements are divided into three primary sections. Each section reviews the cash flow from one of three types of cash generating activities. These activities are operating activities, investing activities, and financing.
As always, a picture speaks a million worlds when it comes to this material. Here’s an example of a two period cash flow statement.
- Statement of Shareholder Equity
The statement of stockholder’s equity shows all equity accounts that shape the ending equity balance including common stock, net income, paid in capital, and dividends.
Stated simply, the statement of stockholder’s equity is a basic settlement of how the ending equity is calculated. The question this statement answers is how did the equity balance on January 1 turn into the equity balance on December 31?
The way the statement is laid out is very simple. First, the starting equity is reported followed by any new investments from shareholders along with net income for the year.
Secondly, all dividends and net losses are subtracted from the equity balance revealing the ending equity balance for the accounting period.
Obviously, net income is needed to calculate the ending equity balance for the year. This is why the statement of changes in equity must be prepared after the income statement.
Here’s an example of what a Statement of Shareholder Equity looks like:
It does not take a CPA or a MBA to conduct basic fundamental analysis. Simply following the basics laid out above when choosing stocks will give you an edge over many investors.