What is Fundamental Analysis
Fundamental analysis is the process of analyzing a company's value (often by interpreting the Financial Statements) to determine the underlying health and value of the company. Comparing the results of a fundamental analysis with its current stock price and other companies educates you on the quality of the investment opportunity.
Fundamental Analysis generally employs qualitative and quantitative components.
Qualitative analysis is the process of understanding the 'soft' attributes of a company. Examples include brand value, customer satisfaction, management team skill, customer loyalty, global presence, growth potential and potential product market value to name a few. Qualitative metrics are very difficult to define and compare with other companies. They are often scored with a Yes/No ( 1 or 0 ) score card to be able to compare across companies. However, due to the potential inherent bias here, qualitative analysis is usually left for the very end; to find the best stock among 5 for example.
Quantitative analysis is the process of analyzing the numbers. Typically investors analyze the Financial Statements of a company. Each statement provides separate insights about the trajectory of the company. At FreeMarketInsights, we use the following metrics in our AI Stock Scorer to score stocks in the universe against each other to identify the stocks that will perform relatively better in the future.
Let's discuss each financial statement and the relevant insights that can be gleamed from the metrics held within.
The purpose of the income statement is to summarize all of the spending a company incurs compared to the revenue (sales) it earns. Net (subtracting the two) yields Net Income (or Profit).
The income statement describes how profitable a company is and is often used by comparing to historical Income Statements to understand growth trends. Growing revenue is good, growing costs are bad. The growth rates of these can determine future profitability. If a company's product can scale we will see revenues growing faster than costs, thus, generating growing Profit Margins. We want to see companies that earn more money, because that money can be re-invested in the company for further growth or improved services or paid back in the form of dividends or stock re-purchases. All outcomes will benefit investors at some point. It is up to the executive team to optimally allocate resources based on what it knows about the company's future growth and ability to use the money if funded.
Profit Margin (Gross Margin)
Earnings per Share
In general, we want these metrics growing and may look at the most recent value and the last 2-5 year growth rate.
The Balance Sheet is the financial statement that details a company's assets (what it owns), liabilities (what it owes), and equity (what its earned). The balance sheet is often considered the most important statement by most investors because it is the only statement that explains what the company actually is. The other statements describe the activities of the company, but don't describe the physical fabric of its make-up. Investors want to see a strong balance sheet which can be analyzed by a variety of metrics. Often times, data-points from other statements are combined with balance sheet data to create efficiency metrics of how effective a company's activity is compared to what it has to work with. Let's look at some examples.
Debt to Equity Ratio
Return on Assets (ROA)
Return on Equity (ROE)
Using these metrics, we can compare to other companies. These data-points are most useful when comparing a strong against its industry or direct competitors. For example, a bank (small profits margins, large amount of assets and liabilities) will have a very different metrics from a biotech company (high margin, small amount of assets), however, comparing two biotech companies using these metrics provides insights into the companies' efficiency and future ability to grow and generate future profits.
Statement of Cash Flows
The Cash Flow statement describes how a company uses its cash. It begins with Net Income, subtracts all the cash consuming activity such as Operating Activities (paying employees a bonus), Investing Activities (buying land), and Financing Activities (buying a company or stock), and adds back non-cash expenses (like depreciation) to determine how much actual cash was used by the company during the period.
Companies with a high cash flow are seen as more valuable because customers are willing to pay cash for a product that does not require cash to make. This inherently means the depreciating assets that the company has are valued by the market and the other cash consuming activities are being paid for with no issues.
Companies with low cash flow are either not generating a lot of profit, or do generate profit, but either:
-Don't have a lot of assets
-Recently used its cash to invest in companies or infrastructure
-Pay its profits out in the form of stock buy-backs or dividends
Each case is less than exciting for investors:
- Not having a lot of assets means your company is run by people. Companies run by people, like consulting companies, don't scale well. Also, without assets, if you were to lose your customers, your company would have no salvage value left from selling your equipment. Effectively, your company is not physically worth anything since people cannot be owned
- Recently using cash to invest can be a good thing for long-term investors, especially if the investment is strategic. However, investments like buying land or equipment often take years to setup before they can generate revenues. Most investors have a shorter horizon than 3+ years, so most investors see this as a negative. Buying a company can generate short term revenues, however, most company acquisitions end up costing the buyer a lot of money with little return, especially in the short run. Most often, the company being purchased is bought at a premium and the acquisition usually takes a while to find synergies.
- Everyone likes dividends and stock buy-backs drive short term price increases, so what is the problem here? Unfortunately, a company that is paying investors back, also is accepting that it does not have a better use for the money. Meaning its future plans for growth are minimal and its innovation is halting. A company not investing in its future can be a huge red flag for investors that are looking at the mid to long term investment horizon.
All three financial statements are very valuable. Using a variety of metrics derived from these statements, then comparing against competitors is an extremely effective way to understand how a company is doing and what to expect from its future. Combining financial statement analysis with qualitative information is how all of the best investors recommend stock picking including Warren Buffet, Ben Graham, Peter Lynch, George Soros, Carl Icahn, Kenneth Fisher, Jim Cramer and others.
Everyone agrees that stock fundamentals are a critical piece of the puzzle. You can click here to see an example and leverage the free market AI stock scorer for advanced users.
Once you have completed your fundamental analysis, the next step is identifying the catalyst. You can read our article about identifying the catalyst to learn more. Our AI stock scorer already comprehends cataclysmic opportunities as well.
At this point, you are on your way to becoming an advanced investor. Continue browsing our other articles to learn more and look out for more in depth articles about specific financial statement metrics; why they are important and what they tell us.
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