Fundamental analysis is the process of looking at a business at the basic or fundamental financial level. This type of analysis examines key ratios of a business to determine its financial health and gives you an idea of the value its stock.
Many investors use fundamental analysis alone or in combination with other tools to evaluate stocks for investment purposes. The goal is to determine the current worth and, more importantly, how the market values the stock.
This article focuses on the key tools of fundamental analysis and what they tell you. Even if you don’t plan to do in-depth fundamental analysis yourself, it will help you follow stocks more closely if you understand the key ratios and terms.
It’s all about earnings. When you come to the bottom line, that’s what investors want to know.
How much money is the company making and how much is it going to make in the future.
Earnings are profits. It may be complicated to calculate, but that’s what buying a company is about. Increasing earnings generally leads to a higher stock price and, in some cases, a regular dividend.
When earnings fall short, the market may hammer the stock. Every quarter, companies report earnings. Analysts follow major companies closely and if they fall short of projected earnings, sound the alarm. For more information on earnings, see my article: It’s the Earnings.
While earnings are important, by themselves they don’t tell you anything about how the market values the stock. To begin building a picture of how the stock is valued you need to use some fundamental analysis tools. These ratios are easy to calculate, but you can find most of them already done on sites like cnn.money.com or MSN MoneyCentral.com.
These are the most popular tools of fundamental analysis. They focus on earnings, growth, and value in the market. For convenience, I have broken them into separate articles. Each article discusses related ratios. There are links in each article to the other articles and back to this article.
The articles are:
8. Book Value
No single number from this list is a magic bullet that will give you a buy or sell recommendation by itself, however as you begin developing a picture of what you want in a stock, these numbers will become benchmarks to measure the worth of potential investments.
From Ken Little,
What traits do excellent businesses have in common? To put the question another way, what are some of the important factors that separate a good stock from just another stock?
For this exercise, I’m going to look at three non-financial characteristics of businesses. The financial analysis is important, but if a business doesn’t possess these important market attributes, it is unlikely it can sustain a leadership position.
Will anyone want their product or service tomorrow? It makes little difference if the company has the hottest product on the market today if it is a passing fad or yesterday’s technology.
VCRs were once the hottest thing in video technology, but now retailers are practically giving the machines away. A major video store has announced they will no longer carry new releases on video tape – everything they stock will be in DVD format.
Great companies have products and services that people want year after year because of their universal appear or because the company keeps the products fresh with shifting consumer concerns.
There is not a railroad or steel maker in the 30 stocks that Dow Jones Industrial Average, yet those two industries created immense wealth for their owners in the not too distant past.
Strong competitive advantages, often called the deep moat, protect great companies from competitors.
These can be high costs of entry, such as in heavy manufacturing (think cars and airplanes); or name recognition like McDonald’s and Coca Cola; or low-price leader, such as Wal-Mart.
These advantages (and superior companies usually have more than one) make it difficult for competitors to grab market share. Dell Computer’s efficient operations let it build a commodity product (the personal computer) cheaper than its competitors did. It was able to grab and hold on to significant market share.
Southwest Airlines is another example of a company that did the same thing as its competitors, but did it better and cheaper.
One of the most important characteristics of a great company is market leadership. Market leaders can set the agenda for their industry.
However, beware of the complacent giants that grow fat and slow in their leadership roles. They will eventually go the way of all companies that rest on past accomplishments and disappear into merger oblivion.
Market leaders set the pace for the industry and use their size to protect their position. They are able to hire top talent and have the resources to keep pushing their advantage.
Market leaders that pause to catch their breath are often passed and they never regain their leadership standing again. IBM is a good example of a company that could have owned the personal computer market, but let it slip away.
These are three non-financial characteristics of great companies. The numbers will usually follow any company that has a durable product or service, a significant competitive advantage and holds a market leadership position.
From Joshua Kennon,
Each autumn, I read Benjamin Graham's Intelligent Investor. Its principles are timeless, unquestionably accurate, and contain a sound intellectual framework for investing that has been tested by decades of experience. As I considered the content of my weekly article, I decided to focus on the seven tests prescribed by Graham in Chapter 14, Stock Selection for the Defensive Investor. Each of these will serve as a filter to weed out the speculative stocks from a conservative portfolio. Note that these guidelines only apply to passive investors seeking to put together a portfolio of solid companies for long-term appreciation; an investor that is capable of financial statement analysis, interpreting accounting decisions, and valuing an asset based on discounted cash flows may take exception to any of the following as long as he is confident his analysis is both conservative and promises safety of principal.
In the world of investing, there is some safety attributable to the size of an enterprise. A smaller company is generally subject to wider fluctuations in earnings. Graham recommended [in 1970] that an industrial company should have at least $100 million of annual sales, and a public utility company should have no less than $50 million in total assets. Adjusted for inflation, the numbers would work out to approximately $465 million and $232 million respectively.
According to Graham, a stock should have a current ratio of at least two. Long-term debt should not exceed working capital. For public utilities the debt should not exceed twice the stock equity at book value. This should act as a strong buffer against the possibility of bankruptcy or default.
The company should not have reported a loss over the past ten years. Companies that can maintain at least some level of earnings are, on the whole, more stable.
The company should have a history of paying dividends on its common stock for at least the past twenty years. This should provide some assurance that future dividends are likely to be paid. For more information on the dividend policy, read Determining Dividend Payout: When Should Companies Pay Dividends?.
To help ensure a company's profits keep pace with inflation, net income should have increased by one-third or greater on a per-share basis over course of the past ten years using three-year averages at the beginning and end.
For inclusion into a conservative portfolio, the current price of a stock should not exceed fifteen times its average earnings for the past three years. This acts as a safeguard against overpaying for a security.
Quoting Graham, "Current price should not be more than 1 1/2 times the book value last reported. However, a multiplier of earnings below 15 could justify a correspondingly higher multiplier of assets. As a rule of thumb we suggest that the product of the multiplier times the ratio of price to book value should not exceed 22.5 (this figure corresponds to 15 times earnings and 1 1/2 times book value. It would admit an issue selling at only 9 times earnings and 2.5 times asset value, etc.)"
You can find more information and a book review of The Intelligent Investor in the top picks section.
From Ken Little,
One of the challenges of evaluating stocks is establishing an “apples to apples” comparison. What I mean by this is setting up a comparison that is meaningful so that the results help you make an investment decision.
Comparing the price of two stocks is meaningless as I point out in my article “Why Per-Share Price is Not Important.”
Similarly, comparing the earnings of one company to another really doesn’t make any sense, if you think about it. Using the raw numbers ignores the fact that the two companies undoubtedly have a different number of outstanding shares.
For example, companies A and B both earn $100, but company A has 10 shares outstanding, while company B has 50 shares outstanding. Which company’s stock do you want to own?
It makes more sense to look at earnings per share (EPS) for use as a comparison tool.
You calculate earnings per share by taking the net earnings and divide by the outstanding shares.
Net Earnings / Outstanding Shares
Using our example above, Company A had earnings of $100 and 10 shares outstanding, which equals an EPS of 10 ($100 / 10 = 10). Company B had earnings of $100 and 50 shares outstanding, which equals an EPS of 2 ($100 / 50 = 2).
So, you should go buy Company A with an EPS of 10, right? Maybe, but not just on the basis of its EPS. The EPS is helpful in comparing one company to another, assuming they are in the same industry, but it doesn’t tell you whether it’s a good stock to buy or what the market thinks of it. For that information, we need to look at some ratios.
Before we move on, you should note that there are three types of EPS numbers:
From Ken Little,
If there is one number that people look at than more any other it is the Price to Earning Ratio (P/E). The P/E is one of those numbers that investors throw around with great authority as if it told the whole story. Of course, it doesn’t tell the whole story (if it did, we wouldn’t need all the other numbers.)
The P/E looks at the relationship between the stock price and the company’s earnings. The P/E is the most popular metric of stock analysis, although it is far from the only one you should consider.
You calculate the P/E by taking the share price and dividing it by the company’s EPS.
P/E = Stock Price / EPS
For example, a company with a share price of $40 and an EPS of 8 would have a P/E of 5 ($40 / 8 = 5).
What does P/E tell you? The P/E gives you an idea of what the market is willing to pay for the company’s earnings. The higher the P/E the more the market is willing to pay for the company’s earnings. Some investors read a high P/E as an overpriced stock and that may be the case, however it can also indicate the market has high hopes for this stock’s future and has bid up the price.
Conversely, a low P/E may indicate a “vote of no confidence” by the market or it could mean this is a sleeper that the market has overlooked. Known as value stocks, many investors made their fortunes spotting these “diamonds in the rough” before the rest of the market discovered their true worth.
What is the “right” P/E? There is no correct answer to this question, because part of the answer depends on your willingness to pay for earnings. The more you are willing to pay, which means you believe the company has good long term prospects over and above its current position, the higher the “right” P/E is for that particular stock in your decision-making process. Another investor may not see the same value and think your “right” P/E is all wrong.
From Ken Little,
In my article on Price to Earnings Ratio or P/E , I noted that this number gave you an idea of what value the market place on a company’s earnings.
The P/E is the most popular way to compare the relative value of stocks based on earnings because you calculate it by taking the current price of the stock and divide it by the Earnings Per Share (EPS). This tells you whether a stock’s price is high or low relative to its earnings.
Some investors may consider a company with a high P/E overpriced and they may be correct. A high P/E may be a signal that traders have pushed a stock’s price beyond the point where any reasonable near term growth is probable.
However, a high P/E may also be a strong vote of confidence that the company still has strong growth prospects in the future, which should mean an even higher stock price.
Because the market is usually more concerned about the future than the present, it is always looking for some way to project out.
Another ratio you can use will help you look at future earnings growth is called the PEG ratio. The PEG factors in projected earnings growth rates to the P/E for another number to remember.
You calculate the PEG by taking the P/E and dividing it by the projected growth in earnings.
PEG = P/E / (projected growth in earnings)
For example, a stock with a P/E of 30 and projected earning growth next year of 15% would have a PEG of 2 (30 / 15 = 2).
What does the “2” mean? Like all ratios, it simply shows you a relationship. In this case, the lower the number the less you pay for each unit of future earnings growth. So even a stock with a high P/E, but high projected earning growth may be a good value.
Looking at the opposite situation; a low P/E stock with low or no projected earnings growth, you see that what looks like a value may not work out that way. For example, a stock with a P/E of 8 and flat earnings growth equals a PEG of 8. This could prove to be an expensive investment.
A few important things to remember about PEG:
If you give some management teams a couple of boards, some glue, and a ball of string, they can build a profitable growing business, while other teams can’t make a profit with several billion dollars worth of assets.
Return on Equity (ROE) is one measure of how efficiently a company uses its assets to produce earnings. You calculate ROE by dividing Net Income by Book Value. A healthy company may produce an ROE in the 13% to 15% range. Like all metrics, compare companies in the same industry to get a better picture.
While ROE is a useful measure, it does have some flaws that can give you a false picture, so never rely on it alone. For example, if a company carries a large debt and raises funds through borrowing rather than issuing stock it will reduce its book value. A lower book value means you’re dividing by a smaller number so the ROE is artificially higher. There are other situations such as taking write-downs, stock buy backs, or any other accounting slight of hand that reduces book value, which will produce a higher ROE without improving profits.
It may also be more meaningful to look at the ROE over a period of the past five years, rather than one year to average out any abnormal numbers.
Given that you must look at the total picture, ROE is a useful tool in identifying companies with a competitive advantage. All other things roughly equal, the company that can consistently squeeze out more profits with their assets, will be a better investment in the long run.
From Ken Little,
With interest rates on the rise, you may want to pay more attention to debt when evaluating a stock for investment. Companies that a carry heavy debt load may be at risk in an environment of rising interest rates.
There are several measurements you can use to gauge whether a company may be carrying too much debt. Both come off the balance sheet if you want to do the math yourself or you can find the ratios on several online services.
The two ratios are part of a set of metrics that help you determine the financial health of a company when you are evaluating its stock for investment. We need two definitions before we move on:
Long-tern debt, such as mortgages would not be included, however that portion of payments due in the next 12 months would be included.
The first ratio is the Quick Ratio. This ratio gives you an idea how easily the company can pay its current obligations – that is those bills due in the next 12 months.
The Quick Ratio is cash, marketable securities and accounts receivable divided by current liabilities (those due in the next 12 months). However, not all Current Assets are included in this ratio - excluded are accounts receivable and inventory. Basically, you are saying if all income stopped tomorrow and the company sold off its readily convertible assets, could it meet its current obligations?
A Quick Ratio of 1.00 means the company has just enough current assets to cover current obligations. Something higher than 1.00 indicates there are more current assets than current obligations.
It is important to compare companies with others in the same sector because different industries operate with ratios that may vary from one sector to another. Some industries such as utilities, for example carry much more debt than other industries and should only be compared to other utilities.
The second ratio is the Current Ratio. The Current Ratio is very similar to the Quick Ratio, but broadens the comparison to include all Current Liabilities and all Current Assets. It measures the same financial strength as the Quick Ratio that is a company’s ability to meet its short-term obligations.
Some analysts like the Current Ratio better because it is more “real world” in that a company would convert every available asset to stay afloat if needed. The Current Ratio measures that better than the Quick Ratio.
Like the Quick Ratio, 1.00 or better is good, and likewise you should always compare companies in the same sector.
Theses two ratios, which you can find on any Web site that offer
quotes, tell you a great deal, about how a company may or may not weather tough
times. Low numbers in these ratios should be a red flag when you are evaluating
See Part Two in this series on debt and evaluating stocks.
From Ken Little,
Should you invest in companies that carry large amounts of debt? That is a question every investor should ask when evaluating stocks.
Unfortunately, the answer isn’t as easy as “yes or no.” The correct answer is “it depends.” The problem is that some industries typically require more debt than others do.
For these industries, a higher debt load is normal. For example, utilities often borrow large sums of money when building new power plants. It may take several years to build the plant, which means no revenue and lots of debt.
However, the useful life of power plants spans many years and when the debt on the plant is repaid the facility can become a real cash cow for the utility.
For other industries, a large debt load may signal something seriously wrong.
Of course, any company might pickup a big note if it just bought a building or a competitor.
There are several tools you can use to determine whether a company is exposing itself to too much debt.
The first is the Debt to Equity Ratio. This ratio tells you what portion of debt and equity is used to finance a company’s assets.
The formula is Total Liabilities / Shareholder Equity = Debt to Equity Ratio.
A ratio of 1 or more indicates the company is using more debt than equity to finance assets. A high number (when compared to peers in the same industry) may mean the company is at risk in a market where interest rates are on the rise.
If a company has debt, it has interest expenses. There is a metric called Interest Coverage that will give you a good idea if a company is having trouble paying the interest charges on its debt.
The formula is: EBITDA / Interest Expense = Interest Coverage.
EBITDA is Earnings Before Interest, Taxes, Depreciation and Amortization and measures the operating performance of a company before accounting conventions and non-operational charges (such as taxes and interest).
The resulting ratio tells you whether a company is having trouble producing enough cash to meet its interest expense. A ratio of 1.5 or higher is where companies want to be. A lower ratio may indicate that the company has trouble covering interest expenses as well as other costs.
Debt is not a bad thing when used responsibly. It can help businesses grow and expand. However, misuse of debt can result in a burden that drags down a company’s earnings.
From Ken Little,
It all comes down to the bottom line.
Well, there’s more than one way to read that sentence and both would be correct. In this article, I am introducing the concept of stock evaluation or how you decide if a company’s stock price accurately reflects its worth.
If you can’t determine a stock’s value, how will you know whether the current price is high, low, or about right? Fortunately, there are many resources to help you evaluate stocks, although you must be careful since some of these sources may be less than objective in their analysis
However, let’s stick with the basics first. For most investors, stock evaluation revolves around the company’s earnings. Everything else either adds to or takes away from the earnings report. Earnings simply are the company’s profit – how much money did it make in any given period.
This is not to say that small or rapidly growing companies with negative earnings have no value or that their earnings’ reports are meaningless – quite the contrary. All earnings reports have meaning in the proper context.
Investors expect established companies like Coca Cola to have positive earnings. If Coke reports lower earnings for a quarter, the stock will likely drop unless there is a reason that explains this as a one-time event. Young companies, on the other hand, may go for years with negative earnings and still enjoy the favor of the market if investors believe in the future of the company.
So, in addition to the actual earnings, is the expectation of earnings. A company may report positive earnings for a quarter, but fall short of expectations and see its stock tumble.
Earnings (or growth towards positive earnings) tell you how healthy a company is and if it may pay dividends or grow through capital appreciation (higher stock price).
The basic measurement of earnings is “earnings per share” or EPS. This measurement divides the earnings by the number of outstanding shares. For example, if a company earned $12 million in the third quarter and had 8 million shares outstanding, the EPS would be $1.50 ($12 million / 8 million).
The reason you reduce earnings to a per share basis is to facilitate comparison with another company and to show how to divide the profit. Two companies that each had $12 million in earnings would look the same with just those raw numbers. However, if one company had 8 million shares outstanding and the other company had 4 million shares outstanding, which stockholders will profit the most.
You can use the earnings per share measurement in three time intervals:
Only the trailing EPS is actual. The current and forward EPS are estimates.
When you hear news commentators talk about “earnings season,” they are referring to the quarterly earnings reports companies have to file with the SEC.
You can look at these reports online via the SEC site called Edgar.
Companies that fail to meet earnings expectations usually make the business news with reports of a falling stock price.
Investors use many other tools in evaluating stocks, but it all begins and usually ends with earnings.
From Ken Little,
How is your portfolio or stock doing? Have you calculated its return lately, and, more importantly, have you calculated its return in a meaningful way?
There are several calculations that will give you an idea of how an investment is doing. Some are more complicated than others are, but none are beyond the reach of the average investor and a calculator.
Here are several calculations you can use to help you understand how your investments are doing.
This is a simple calculation, but it reminds us that we need to include dividends (where appropriate) when figuring the return of a stock. Here is the formula:
(Value of investment at the end of the year – Value of investment at beginning of the year) + Dividends / Value of investment at beginning of the year = Total Return
For you bought a stock for $7,543 and it is now worth $8,876, you have an unrealized gain of $1,333.
You also received dividends during this time of $350. What is the total return?
- $7,543) + $350 / $7,543 = Total Return
$1,333 + $350 / $7,543 = Total Return
$1,683 / $7,543 = Total Return
0.2231 or 22.31% = Total Return
You can use this calculation for any time period, which is a weakness since it doesn’t take into account the time value of money.
Simple return is similar to total return, however it is used to calculate your return on an investment after you have sold it.
Here is the formula:
Net Proceeds + Dividends / Cost Basis - 1
Let’s run through an example. Suppose you bought a stock for $3,000 and paid a $12 commission. Your cost basis is $3,012. You sell the stock for $4,000 and there is another $12 commission, so your net proceeds are $3,988. Dividends amounted to $126.
$126 / $3,012 - 1 = Simple Return
$4,114 / $3,012 – 1 = Simple Return
1.36 – 1 = Simple Return
0.36 or 36% = Simple Return
Like the Total Return calculation, the Simple Return tells you nothing about how long the investment was held. If you want to see after-tax returns, simply substitute “net proceeds after taxes” for the first variable and use an after tax dividend number.
For investment held more than one year, you may want to look at this more sophisticated, but not much more complicated calculation.
The Compound Annual Growth Rate shows you the time value of money in your investment. A 40 percent return over two years is great, but a 40 percent return over ten years leaves much to be desired.
I devote a whole article on this important calculation. You can find it by clicking here.
Simple or slightly more complicated calculations can give you a better fix on how your investments are doing.