Investing Basics: Fundamental Analysis
To end this series, let’s examine one of the most generally used strategies of some of the world’s greatest and most successful investors like Ray Dalio and Warren Buffet – Fundamental Analysis. Fundamental analysis is one of my favorites and precisely why I became an auditor at a prestigious accounting firm. I love dissecting financial data and determining relationships among the data of individual companies, and discerning if a company is growing, stagnant, or clamming up. To get the record straight, everyone seems to think that as an accountant that works at an accounting firm, I am confined to a cube and do people’s 1040’s all day. This is not at all what I do. Even the firm’s tax people don’t really do that. I am an auditor, which means I visit companies and evaluate the financial information they provide. Then, as a firm, we give an opinion on those statements and a lending agent, bonding agent, or a state or federal agency relies on our independent opinion of the company’s financial position. Interacting with clients and servicing them is one of the many highlights to my career!
Fundamental analysis is the process of examining a company’s financial statements to help decide if a stock is a good investment. Financial statements include balance sheets, income statements, and cash flow statements. This information helps determine the financial makeup of a company behind the stock. I will explain how fundamental analysis uses these statements to help evaluate a company.
Let’s start with a balance sheet. This document compares a company’s current (held on a particular date) assets to its liabilities and owner’s equity. Let’s define these terms. First, we have assets, which are items the company owns. Assets are usually comprised of cash, equipment, and property. Next is liabilities. Liabilities are usually accounts that need to be paid. Often, a liability on a balance sheet has an offsetting asset that helps the number stay level. For example, if a company were to take a loan out to buy property, the loan would be a liability and the property would be an asset. The third term of a balance sheet is capital, or owner’s equity, which is the amount of assets raised by issuing stock. For example, when a company issues stock, either in its initial public offering or in a secondary offering, it is raising capital that can be used to fund various business expenses. Balance is achieved when the value of the assets are equal to the liabilities and owner’s equity. The balance sheet helps you see how a company raises money for its assets and can help you determine if the company is over-extended (or over-leveraged, meaning that the company has taken on too much debt). However, if you want to know how the company earns money, you look at its income statement.
An income statement shows a company’s revenues (also commonly referred to as sales) and expenses. These are the costs associated with running the business, including operations, interest paid on loans, and taxes. When you take revenues and subtract expenses you get net income / loss. Net income is the earnings of a company. Earnings are usually handled in two ways. The first way is to share the earnings with shareholders by paying a dividend. The second way is to reinvest these earnings into the company. Reinvesting earnings can help a company’s cash position. A company with a good cash position is usually better prepared to endure economic ups and downs. This is why some investors say, “Cash is king.” It’s also why the cash flow statement is an important item to consider.
The statement of cash flows shows how the company uses its cash to operate the business, make investments, and borrow from a bond-holder. These items, operations, investments, and financing (debt) are totaled to show changes in the company’s overall cash position. This statement is important because it gives a more detailed account of how the business generates revenue and is therefore much more difficult to manipulate than an income statement.
As you can see, there is a lot of information in the three primary financial statements. With all of these facts and figures, analysis can be a little tricky. This is why some investors use ratios. There are several ratios (price/earnings, price/book value, debt/equity, return on equity, current ratio, net profit margin, etc.) that can help an investor compare stocks, but we will focus on the most common.
We will look at Price to Earnings, or the P/E ratio. Let’s say you have one stock that trades at $6/share, another at $35/share, and a third at $132/share. How would you know which one is the best value? Some might assume the $6 stock is the best value because it’s the cheapest. However, this might not be the case because a company’s value depends on the company’s earnings. The P/E Ratio allows you to look beyond the price of a stock to see which company could be the best value. To create this ratio, divide Net income by the number of outstanding shares. This number is called earnings per share, or EPS. Next, divide the price of the stock by the EPS to get the P/E ratio. The first stock is trading at $6 and has an EPS of $.20 ($6/$.20 = 30), resulting in a P/E of 30. The second company is trading at $35/share and has an EPS of $1.40 resulting in a P/E of 25. The final company is trading at $132/share and has an EPS of $3.90 for a P/E of 34. Now, you can better compare each company by its P/E ratio. Despite the differing stock prices, the stocks appear to have a similar valuation. However, the second company has the lowest P/E ratio and therefore appears to be the best value.
Remember, a P/E ratio is only one of several financial ratios to evaluate a company. There are countless other ratios to determine profitability and financial strength. There are also other figures to examine in financial statements. We have only scratched the surface. It is important to subscribe to my blog so you can continue to learn more! I am here to help you every step of the way. If you like this post, share it on Facebook, Twitter, or LinkedIn!! Thanks for your support!
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