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Fundamental Analysis
(http://www.investopedia.com/university/fundamentalanalysis/)
· What is fundamental analysis?
Fundamental analysis is a technique that attempts to determine a security’s value by focusing on underlying factors that affect a company's actual business and its future prospects.
Fundamental analysis serves to answer questions, such as:
Ø Is the company’s revenue growing?
Ø Is it actually making a profit?
Ø Is it in a strong-enough position to beat out its competitors in the future?
Ø Is it able to repay its debts?
Ø Is management trying to "cook the books"?
However, the big unknowns are:
1)You don’t know if your estimate of intrinsic value is correct; and
2)You don’t know how long it will take for the intrinsic value to be reflected in the marketplace.
· Qualitative Factors – the company
Business Model
What exactly does the company do? This is referred to as a company's business model – it's how a company makes money. The plan implemented by a company to generate revenue and make a profit from operations. The model includes the components and functions of the business, as well as the revenues it generates and the expenses it incurs.
Competitive Advantage
Another business consideration for investors is competitive advantage. A company's long-term success is driven largely by its ability to maintain a competitive advantage - and keep it.
Management
Just as an army needs a general to lead it to victory, a company relies upon management to steer it towards financial success. Some believe that management is the most important aspect for investing in a company. It makes sense - even the best business model is doomed if the leaders of the company fail to properly execute the plan.
Here are a few ways for you to get a feel for management:
1. Conference Calls
The CEO and CFO host quarterly conference calls.
2. Management Discussion and Analysis (MD&A)
The Management Discussion and Analysis is found at the beginning of the annual report (discussed in more detail later in this tutorial). In theory, the MD&A is supposed to be frank commentary on the management's outlook. Sometimes the content is worthwhile, other times it's boilerplate. One tip is to compare what management said in past years with what they are saying now. Is it the same material rehashed? Have strategies actually been implemented? If possible, sit down and read the last five years of MD&As; it can be illuminating.
3. Ownership and Insider Sales
Just about any large company will compensate executives with a combination of cash, restricted stock and options. While there are problems with stock options, it is a positive sign that members of management are also shareholders. The ideal situation is when the founder of the company is still in charge. Examples include Bill Gates (in the '80s and '90s), Michael Dell and Warren Buffett. When you know that a majority of management's wealth is in the stock, you can have confidence that they will do the right thing. As well, it's worth checking out if management has been selling its stock. This has to be filed with the Securities and Exchange Commission (SEC), so it's publicly available information. Talk is cheap - think twice if you see management unloading all of its shares while saying something else in the media.
4. Past Performance
Another good way to get a feel for management capability is to check and see how executives have done at other companies in the past. You can normally find biographies of top executives on company web sites. Identify the companies they worked at in the past and do a search on those companies and their performance.
Corporate Governance
Corporate governance describes the policies in place within an organization denoting the relationships and responsibilities between management, directors and stakeholders. These policies are defined and determined in the company charter and its bylaws, along with corporate laws and regulations. The purpose of corporate governance policies is to ensure that proper checks and balances are in place, making it more difficult for anyone to conduct unethical and illegal activities.
Financial and Information Transparency
This aspect of governance relates to the quality and timeliness of a company's financial disclosures and operational happenings. Sufficient transparency implies that a company's financial releases are written in a manner that stakeholders can follow what management is doing and therefore have a clear understanding of the company's current financial situation.
Stakeholder Rights
This aspect of corporate governance examines the extent that a company's policies are benefiting stakeholder interests, notably shareholder interests. Ultimately, as owners of the company, shareholders should have some access to the board of directors if they have concerns or want something addressed. Therefore companies with good governance give shareholders a certain amount of ownership voting rights to call meetings to discuss pressing issues with the board.
Another relevant area for good governance, in terms of ownership rights, is whether or not a company possesses large amounts of takeover defenses (such as the Macaroni Defense or the Poison Pill) or other measures that make it difficult for changes in management, directors and ownership to occur. (To read more on takeover strategies, see The Wacky World of M&As.)
Structure of the Board of Directors
The board of directors is composed of representatives from the company and representatives from outside of the company. The combination of inside and outside directors attempts to provide an independent assessment of management's performance, making sure that the interests of shareholders are represented.
The key word when looking at the board of directors is independence. The board of directors is responsible for protecting shareholder interests and ensuring that the upper management of the company is doing the same. The board possesses the right to hire and fire members of the board on behalf of the shareholders.
· Qualitative Factors – the industry
A deeper understanding of a company's financial health.
Customers
Some companies serve only a handful of customers, while others serve millions. In general, it's a red flag (a negative) if a business relies on a small number of customers for a large portion of its sales because the loss of each customer could dramatically affect revenues.
Market Share
Market share is important because of economies of scale. When the firm is bigger than the rest of its rivals, it is in a better position to absorb the high fixed costs of a capital-intensive industry.
Industry Growth
One way of examining a company's growth potential is to first examine whether the amount of customers in the overall market will grow. This is crucial because without new customers, a company has to steal market share in order to grow.
Competition
One of the biggest risks within a highly competitive industry is pricing power. This refers to the ability of a supplier to increase prices and pass those costs on to customers. Companies operating in industries with few alternatives have the ability to pass on costs to their customers. A great example of this is Wal-Mart. They are so dominant in the retailing business, that Wal-Mart practically sets the price for any of the suppliers wanting to do business with them. If you want to sell to Wal-Mart, you have little, if any, pricing power.
Regulation
Certain industries are heavily regulated due to the importance or severity of the industry's products and/or services. As important as some of these regulations are to the public, they can drastically affect the attractiveness of a company for investment purposes.
In industries where one or two companies represent the entire industry for a region (such as utility companies), governments usually specify how much profit each company can make. In these instances, while there is the potential for sizable profits, they are limited due to regulation.
· Financial statement
The Major Statements
The Balance Sheet
The balance sheet represents a record of a company's assets, liabilities and equity at a particular point in time.
Assets = Liabilities + Shareholders’ Equity
Assets represent the resources that the business owns or controls at a given point in time. This includes items such as cash, inventory, machinery and buildings. The other side of the equation represents the total value of the financing the company has used to acquire those assets. Financing comes as a result of liabilities or equity. Liabilities represent debt (which of course must be paid back), while equity represents the total value of money that the owners have contributed to the business - including retained earnings, which is the profit made in previous years.
The Income Statement
While the balance sheet takes a snapshot approach in examining a business, the income statement measures a company's performance over a specific time frame. Technically, you could have a balance sheet for a month or even a day, but you'll only see public companies report quarterly and annually.
The income statement presents information about revenues, expenses and profit that was generated as a result of the business' operations for that period.
Statement of Cash Flows
The statement of cash flows represents a record of a business' cash inflows and outflows over a period of time. Typically, a statement of cash flows focuses on the following cash-related activities:
- Operating Cash Flow (OCF): Cash generated from day-to-day business operations
- Cash from investing (CFI): Cash used for investing in assets, as well as the proceeds from the sale of other businesses, equipment or long-term assets
- Cash from financing (CFF): Cash paid or received from the issuing and borrowing of funds
10-K and 10-Q
In the United States, the Securities And Exchange Commission (SEC) requires all companies that are publicly traded on a major exchange to submit periodic filings detailing their financial activities, including the financial statements mentioned above.
The 10-K must be filed within 60 days (it used to be 90 days) after the end of the fiscal year.
10-K = Yearly
10-Q = Quarterly
· Other sections
Management Discussion and Analysis (MD&A)
As a preface to the financial statements, a company's management will typically spend a few pages talking about the recent year (or quarter) and provide background on the company. This is referred to as the management discussion and analysis (MD&A). In addition to providing investors a clearer picture of what the company does, the MD&A also points out some key areas in which the company has performed well.
Here are some things to look out for:
- How candid and accurate are management's comments?
- Does management discuss significant financial trends over the past couple years? (As we've already mentioned, it can be interesting to compare the MD&As over the last few years to see how the message has changed and whether management actually followed through with its plan.)
- How clear are management's comments? If executives try to confuse you with big words and jargon, perhaps they have something to hide.
- Do they mention potential risks or uncertainties moving forward?
The Auditor's Report
The auditors' job is to express an opinion on whether the financial statements are reasonably accurate and provide adequate disclosure. This is the purpose behind the auditor's report, which is sometimes called the "report of independent accountants".
By law, every public company that trades stocks or bonds on an exchange must have its annual reports audited by a certified public accountants firm. An auditor's report is meant to scrutinize the company and identify anything that might undermine the integrity of the financial statements.
The typical auditor's report is almost always broken into three paragraphs and written in the following fashion:
Independent Auditor's Report
Paragraph 1
Recounts the responsibilities of the auditor and directors in general and lists the areas of the financial statements that were audited.
Paragraph 2
Lists how the generally accepted accounting principles (GAAP) were applied, and what areas of the company were assessed.
Paragraph 3
Provides the auditor's opinion on the financial statements of the company being audited. This is simply an opinion, not a guarantee of accuracy.
The Notes to the Financial Statements
The footnotes list important information that could not be included in the actual ledgers.
Generally speaking there are two types of footnotes:
Accounting Methods - This type of footnote identifies and explains the major accounting policies of the business that the company feels that you should be aware of. This is especially important if a company has changed accounting policies. It may be that a firm is practicing "cookie jar accounting" and is changing policies only to take advantage of current conditions in order to hide poor performance.
Disclosure - The second type of footnote provides additional disclosure that simply could not be put in the financial statements. The financial statements in an annual report are supposed to be clean and easy to follow. To maintain this cleanliness, other calculations are left for the footnotes.
· Income Statement
Revenue as an investor signal
Revenue, also commonly known as sales, is generally the most straightforward part of the income statement.
The best way for a company to improve profitability is by increasing sales revenue.
What are the Expenses?
There are many kinds of expenses, but the two most common are the cost of goods sold (COGS) and selling, general and administrative expenses (SG&A). Cost of goods sold is the expense most directly involved in creating revenue. It represents the costs of producing or purchasing the goods or services sold by the company.
Next, costs involved in operating the business are SG&A. This category includes marketing, salaries, utility bills, technology expenses and other general costs associated with running a business. Remember, some corporate expenses, such as research and development (R&D) at technology companies, are crucial to future growth and should not be cut, even though doing so may make for a better-looking earnings report. Finally, there are financial costs, notably taxes and interest payments, which need to be considered.
Profits = Revenue - Expenses
Profit, most simply put, is equal to total revenue minus total expenses. However, there are several commonly used profit subcategories that tell investors how the company is performing.
Gross profit is calculated as revenue minus cost of sales.
The gross margin represents the percent of total sales revenue that the company retains after incurring the direct costs associated with producing the goods and services sold by a company. The higher the percentage, the more the company retains on each dollar of sales to service its other costs and obligations.
Gross Margin (%) = (Revenue –Cost of Goods Sold) / Revenue
Operating profit is equal to revenues minus the cost of sales and SG&A. The amount of profit realized from a business's own operations, but excluding operating expenses (such as cost of goods sold) and depreciation from gross income.
Calculated as:
Operating Income = Gross Income – Operating Expenses -Depreciation
Net income generally represents the company's profit after all expenses, including financial expenses, have been paid. This number is often called the "bottom line" and is generally the figure people refer to when they use the word "profit" or "earnings".
· Balance Sheet
The Balance Sheet's Main Three
Assets, liability and equity are the three main components of the balance sheet.
Assets
There are two main types of assets: current assets and non-current assets. Current assets are likely to be used up or converted into cash within one business cycle - usually treated as twelve months. Three very important current asset items found on the balance sheet are: cash, inventories and accounts receivables.
Non-current assets are defined as anything not classified as a current asset. This includes items that are fixed assets, such as property, plant and equipment (PP&E). Unless the company is in financial distress and is liquidating assets,
Liabilities
There are current liabilities and non-current liabilities. Current liabilities are obligations the firm must pay within a year, such as payments owing to suppliers. Non-current liabilities, meanwhile, represent what the company owes in a year or more time. Typically, non-current liabilities represent bank and bondholder debt.
Look at the quick ratio. Subtract inventory from current assets and then divide by current liabilities. If the ratio is 1 or higher, it says that the company has enough cash and liquid assets to cover its short-term debt obligations.
Quick Ratio = (Current Assets – Inventories) / Current Liabilities
Equity
Equity represents what shareholders own, so it is often called shareholder's equity. As described above, equity is equal to total assets minus total liabilities.
Equity = Total Assets – Total Liabilities
The two important equity items are paid-in capital and retained earnings. Paid-in capital is the amount of money shareholders paid for their shares when the stock was first offered to the public.
· Cash Flow
The cash flow statement shows how much cash comes in and goes out of the company over the quarter or the year.
Three Sections of the Cash Flow Statement
Companies produce and consume cash in different ways, so the cash flow statement is divided into three sections: cash flows from operations, financing and investing. Basically, the sections on operations and financing show how the company gets its cash, while the investing section shows how the company spends its cash.
Cash Flows from Operating Activities
Investors tend to prefer companies that produce a net positive cash flow from operating activities. Watch out for a widening gap between a company's reported earnings and its cash flow from operating activities. If net income is much higher than cash flow, the company may be speeding or slowing its booking of income or costs.
Cash Flows from Investing Activities
This section largely reflects the amount of cash the company has spent on capital expenditures, such as new equipment or anything else that needed to keep the business going.
Cash Flow From Financing Activities
This section describes the goings-on of cash associated with outside financing activities. Typical sources of cash inflow would be cash raised by selling stock and bonds or by bank borrowings.
Cash Flow Statement Considerations:
The most common method of calculating free cash flow is:
Free Cash Flow = Net Income
+ Amortization / Depreciation
– Changes in working capital
– Capital Expenditures
