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Overview
Fundamental analysis is the study of economic, industry, and company conditions in an effort to determine the value of a company's stock. Fundamental analysis typically focuses on key statistics in a company's financial statements to determine if the stock price is correctly valued. I realize that some people will find a discussion on fundamental analysis within a book on technical analysis peculiar, but the two theories are not as different as many people believe. It is quite popular to apply technical analysis to charts of fundamental data, for example, to compare trends in interest rates with changes in security prices. It is also popular to use fundamental analysis to select securities and then use technical analysis to time individual trades. Even diehard technicians can benefit from an understanding of fundamental analysis (and vice versa).
INTRODUCTION
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 goal of this tutorial is to provide a foundation for understanding fundamental analysis. It's geared primarily at new investors who don't know a balance sheet from an
income statement .While you may not be a "stock-picker extraordinaire" by the end of this tutorial, you will have a much more solid grasp of the language and concepts behind security analysis and be able to use this to further your knowledge in other areas without feeling totally lost.
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. A good part of this tutorial will be spent learning about the balance sheet, income statement, cash flow statement and how they all fit together.
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. Finally, we'll wrap up the tutorial with an intro on valuation and point you in the direction of additional tutorials you might be interested in.
Interpretation
Most fundamental information focuses on economic, industry, and company statistics. The typical approach to analyzing a company involves four basic steps: 1. Determine the condition of the general economy.
2. Determine the condition of the industry. 3. Determine the condition of the company. 4. Determine the value of the company's stock.
Economic Analysis
The economy is studied to determine if overall conditions are good for the stock market. Is inflation a concern? Are interest rates likely to rise or fall? Are consumers spending? Is the trade balance favorable? Is the money supply expanding or contracting? These are just some of the questions that the fundamental analyst would ask to determine if economic conditions are right for the stock market.
Industry Analysis
The company's industry obviously influences the outlook for the company. Even the best stocks can post mediocre returns if they are in an industry that is struggling. It is often said that a weak stock in a strong industry is preferable to a strong stock in a weak industry.
Company Analysis
After determining the economic and industry conditions, the company itself is analyzed to determine its financial health. This is usually done by studying the company's financial statements. From these statements a number of useful ratios can be calculated. The ratios fall under five main categories: profitability, price, liquidity, leverage, and efficiency. When performing ratio analysis on a company, the ratios should be compared to other companies within the same or similar industry to get a feel for what is considered "normal." At least one popular ratio from each category is shown below.
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 dont plan to do in-depth fundamental analysis yourself, it will help you follow stocks more closely if you understand the key ratios and terms.
Earnings
Its all about earnings. When you come to the bottom line, thats 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 thats 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: Its the Earnings. While earnings are important, by themselves they dont 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
articles. Each article discusses related ratios. There are links in each article to the other articles and back to this article. The articles are:
1. 2. 3. 4. 5. 6. 7. 8. 9.
Earnings per Share EPS Price to Earnings Ratio P/E Projected Earning Growth PEG Price to Sales P/S Price to Book P/B Dividend Payout Ratio Dividend Yield Book Value Return on Equity
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.
Using our example above, Company A had earnings of $100 and 10 shares outstanding, which equals an EPS of 10 (100 rs / 10 = 10). Company B had earnings of 100 rs and 50 shares outstanding, which equals an EPS of 2 (100 rs / 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 doesnt tell you whether its 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:
Trailing EPS last years numbers and the only actual EPS Current EPS this years numbers, which are still projections Forward EPS future numbers, which are obviously projections
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. The articles in this series:
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:
It is about year-to-year earnings growth It relies on projections, which may not always be accurate
P/S = Market Cap / Revenues or P/S = Stock Price / Sales Price Per Share
Much like P/E, the P/S number reflects the value placed on sales by the market. The lower the P/S, the better the value, at least thats the conventional wisdom. However, this is definitely not a number you want to use in isolation. When dealing with a young company, there are many questions to answer and the P/S supplies just one answer.
The real question is whether 33% is good or bad and that is subject to interpretation. Growing companies will typically retain more profits to fund growth and pay lower or no dividends. Companies that pay higher dividends may be in mature industries where there is little room for growth and paying higher dividends is the best use of profits (utilities used to fall into this group, although in recent years many of them have been diversifying). Either way, you must view the whole DPR issue in the context of the company and its industry. By itself, it tells you very little.
Dividend Yield = annual dividend per share / stock's price per share
For example, if a companys annual dividend is $1.50 and the stock trades at $25, the Dividend Yield is 6%. ($1.50 / $25 = 0.06)
Another way to determine a companys value is to go to the balance statement and look at the Book Value. The Book Value is simply the companys assets minus its liabilities.
Value Spotting
Sound fundamental analysis will help identify companies that represent a good value. Some of the most legendary investors think long-term and value. Graham and Dodd, Warren Buffett and John Neff are seen as the champions of value investing. Fundamental analysis can help uncover companies with valuable assets, a strong balance sheet, stable earnings, and staying power.
Business Acumen
One of the most obvious, but less tangible, rewards of fundamental analysis is the development of a thorough understanding of the business. After such painstaking research and analysis, an investor will be familiar with the key revenue and profit drivers behind a company. Earnings and earnings expectations can be potent drivers of equity prices. Even some technicians will agree to that. A good understanding can help investors avoid companies that are prone to shortfalls and identify those that continue to deliver. In addition to understanding the business, fundamental analysis allows investors to develop an understanding of the key value drivers and companies within an industry. A stock's price is heavily influenced by its industry group. By studying these groups, investors can better position themselves to identify opportunities that are high-risk (tech), low-risk (utilities), growth oriented (computer), value driven (oil), non-cyclical (consumer staples), cyclical (transportation) or income-oriented (high yield).
Fundamental analysis may offer excellent insights, but it can be extraordinarily timeconsuming. Time-consuming models often produce valuations that are contradictory to the current price prevailing on Wall Street. When this happens, the analyst basically claims that the whole street has got it wrong. This is not to say that there are not misunderstood companies out there, but it is quite brash to imply that the market price, and hence Wall Street, is wrong.
Industry/Company Specific
Valuation techniques vary depending on the industry group and specifics of each company. For this reason, a different technique and model is required for different industries and different companies. This can get quite time-consuming, which can limit the amount of research that can be performed. A subscription-based model may work great for an Internet Service Provider (ISP), but is not likely to be the best model to value an oil company.
Subjectivity
Fair value is based on assumptions. Any changes to growth or multiplier assumptions can greatly alter the ultimate valuation. Fundamental analysts are generally aware of this and use sensitivity analysis to present a base-case valuation, an average-case valuation and a worst-case valuation. However, even on a worst-case valuation, most models are almost always bullish, the only question is how much so. The chart below shows how stubbornly bullish many fundamental analysts can be.
Analyst Bias
The majority of the information that goes into the analysis comes from the company itself. Companies employ investor relations managers specifically to handle the analyst community and release information. As Mark Twain said, "there are lies, damn lies, and statistics." When it comes to massaging the data or spinning the announcement, CFOs and investor relations managers are professionals. Only buyside analysts tend to venture past the company statistics. Buy-side analysts work for mutual funds and money managers. They read the reports written by the sell-side analysts who work for the big brokers (CIBC, Merrill Lynch, Robertson Stephens, CS First Boston, Paine Weber, DLJ to name a few). These brokers are also involved in underwriting and investment banking for the companies. Even though there are restrictions in place to prevent a conflict of interest, brokers have an ongoing relationship with the company under analysis. When reading these reports, it is important to take into consideration any biases a sell-side analyst may have. The buyside analyst, on the other hand, is analyzing the company purely from an investment standpoint for a portfolio manager. If there is a relationship with the company, it is usually on different terms. In some cases this may be as a large shareholder.
ANALYSIS
Topics Adjusted EPS(Rs) Cash EPS (Rs) Book Value (Rs) Dividend Per Share (Rs)
Steel Authority of India (SAIL) Ltd. (803) 17.7 20.87 55.69 3.7
Return On NetWorth (%) Return On Capital employed(%) Operating Profit Margin(%) Gross Profit Margin(%) Net Profit Margin(%) Current Ratio Quick Ratio Long term debt to equity Total Debt to equity Interest Cover (times) Assets Turnover Ratio Average Raw Material Holding (in Days) Average Finished Good Holding (in Days) Number of days of net working capital Inventory Turnover Ratio Export as percent of Total Sales Bonus component in Equity(%)
21.52 17.16 41.94 37.7 23.43 3.92 3.52 1.07 1.08 9.25 1.2 71.68 29.45 520.93 10.84 11.64 34.61
5.59 12.35 20.42 14.51 3.23 0.52 0.28 1.34 1.51 3.64 0.82 33.03 23.67 -111.72 8.75 29.94 0
32.76 44.47 28.19 25.1 18.16 1.73 1.23 0.12 0.13 51.04 1.31 36.42 48.69 104.06 8.62 3.08 0