There are two general schools of thought concerning how to pick stocks. Fundamental Analysis examines the basic nature of fundamental analysis, the examination and analysis of financial statements and related news and trends, and how the indicators found in the historical record are used to pick companies and then buy their stock.
The second approach is technical analysis, or the analysis of price and chart patterns to spot reversals in trends and to time the purchase or sale of stock.
The most important difference between fundamental and technical is in the nature of data used.
Fundamentals focus on the published results of operations; technicals involve price patterns and changes.
On the fundamental side, the starting point of analysis of the most recent results of operations is found each year in the annual report. This not only summarizes the financial statements, but includes management’s explanation of the financial record, markets, products, or services, and how the company plans to compete in the immediate future.
The annual report is available on the website for a listed company. Most provide the report in either PDF or HTML format, or the report can be requested for delivery in hard copy. This is true for nearly all of the companies whose shares are traded publicly and owned by either institutional investors or retail investors.
The annual report is valuable because it includes extensive narrative sections explaining the significance of the numbers found in the financial statements. However, annual reports also have three major drawbacks for the purpose of performing in-depth analysis of trends:
The annual report is a valuable source for information; but it also has limitations. You get much better information from free research services that summarize important indicators and give you many years’ history.
The drawbacks in annual reports are best overcome by relying on a longer-term summary of not only the key financial results, but the important indicators as well. Most online brokerage services provide members with free analytical services. One of the best of these is the S&P Stock Report, which is available for over 5,000 listed companies. This is provided free of charge to subscribers of Charles Schwab & Co., TD Waterhouse, Scottrade, and e*Trade. The S&P Stock Reports contain a wealth of information for a 10-year period. This includes not only the key information you find in the financial statements but other valuable information as well for 10 years, including:
The core earnings deserve an additional explanation. Under the rules accountants use, some nonrecurring transactions are allowed to be included in net earnings. However, Standard & Poor’s developed a calculation to isolate the net profit from the company’s ‘core’ or primary business. The differences between net income and core net income can be substantial, so this is a valuable additional form of fundamental information.
Reported net income is not always the most accurate summary of what took place for the year. For that you need to track core earnings and to be aware of the changes between net and core — the bigger the changes, the less accurate the traditional fundamental indicators.
Financial statements are prepared in a well-defined but archaic format. This means that much of the valuable information you need in order to track fundamental trends is simply not available from the latest published financial statements or annual reports. This is why you will find it more convenient to make use of services like the S&P Stock Reports for 10 years of history, rather than trying to master financial statements and how they work. However, it is also important for every fundamental investor to know what financial statements contain and what they reveal.
There are two kinds of financial statements and both follow a long-standing format of reporting. So if you understand how one set of financial statements is organized, you are well suited to follow any other corporate financial statement as well.
The first of these two is the balance sheet. It is given this name for two reasons. First, it summarizes the ending balances of all asset, liability, and net worth accounts as of a specific date.
That date is the ending date of the period being reported, usually the last day of the quarter or fiscal year. Second, the sum of all asset account balances is equal to the sum of liabilities plus net worth accounts.
The first component of the balance sheet is a category called current assets. These are all assets in the form of cash or that are convertible to cash within 12 months. Included are cash, accounts receivable, notes receivable, marketable securities, and inventory.
In order, after current assets, the next group is called long-term assets (also called ‘fixed assets’). This is the net value of all capital assets minus accumulated depreciation.
After these two categories, additional asset groups include prepaid assets, deferred assets, and intangible assets. Prepays or deferrals are the values of expenses properly covering more than one year, and set up for annual amortization reducing the asset, and transferring relevant portions to expense. Deferred assets are entire sums paid in advance but properly belonging to a future fiscal year. They are placed in the asset account until transferred to the expense category later. Intangible assets are all assets without physical value, including the assigned value of goodwill or covenants not to compete.
The asset accounts are added together to report the total of the corporation’s properties, before being reduced by offsetting debts and obligations. It is important to use the subdivisions listed above, because so many ratios and indicators rely on distinctions between various asset classes.
The subcategories of financial statements are critically important. Many key ratios are based on isolated classes of accounts.
Assets are the top half of the balance sheet. On the bottom half are two main groups, liabilities and net worth. Liabilities include all of the debts and obligations (as well as any deferred credits), and net worth is the sum of capital stock, retained earnings, and other ownership accounts. Examples of ‘other’ accounts include treasury stock, which is the value of corporate stock the company purchases on the open market and retires permanently.
The total of all liabilities plus net worth accounts is always equal to the total of all assets, without exception.
The first group under the liabilities section is current liabilities. This is the sum of all debts payable within 12 months, including accounts and taxes payable and the current portion (12 months) of all long-term liabilities.
Next are the long-term liabilities, which are all debts owed by the company beyond the next 12 months. These include notes or contracts payable as well as the outstanding balances of bonds issued.
A final section included on this part of the balance sheet is not actually a liability, but a form of revenue received but not yet earned. All such deferred credits are assigned to this category. For example, a customer prepays a large purchase. The corporation has received the cash but it will not be earned until next year. In the current year, this is set up as a deferred credit.
The final section of the balance sheet is the net worth section. This includes capital stock and retained earnings as well as any other additional forms of net worth or adjustments. The sum of all net worth accounts is added to the sum of all liability accounts, and that total is identical to the sum of all asset accounts.
Note: How is the balance accomplished? The sum of liabilities and net worth is always equal to the value of all asset accounts because of double-entry bookkeeping. Every entry has a debit and a credit and these are equal in value. They may also be thought of as a plus and a minus. At any time, the sum of all accounts in the corporate books will add up to zero, because debits and credits offset one another.
The second type of financial statement is the income statement (also called ‘profit and loss statement’ or ‘statement of operations’). This statement summarizes all revenue, costs, expenses, and profits for a specified period of time, such as a quarter or fiscal year.
Like the balance sheet, the income statement is divided into distinct sections. This is crucial for analysis as well as comparisons between companies.
The income statement can be easily summarized by its major parts and subtotals:
The category of cost of goods sold (also called direct costs) includes all expenditures that are assignable directly to revenue production, including merchandise purchased, manufacturing or production labor (direct labor), freight, and the net change in inventory levels for the year.
The cost of goods sold is expected to rise and fall along with revenue, and the percentage of these costs to revenue is expected to remain fairly constant. Changes may occur as a result of mergers and acquisitions, or disposal of an operating segment, when the mix of products also changes as a result.
When the cost of goods sold is subtracted from revenue, the resulting dollar value is called gross profit. Like the cost of goods sold, gross profit is expected to remain at about the same percentage level of revenue from year to year. This may change due to improved efficiencies, changes in inventory practices or valuation, and changes in market pricing.
Next, the expenses are deducted. These may be finely broken down into major groups such as selling expenses and general and administrative expenses (overhead), although most income statements show single values only and may explain the details through a footnote or supplementary schedule. When expenses are deducted from gross profit, the result is the net operating profit.
Next, ‘other’ income and expenses are added or deducted. These include items such as currency exchange, one-time losses or adjustments, proceeds from the sale of capital assets, interest income or expenses, income from trading in derivatives, and all other nonoperating profit or loss. When the other income and expense net is added to or deducted from net operating profit, the result is called pretax profit. If other income exceeds other expense, the change will increase the net profit. If other expenses are greater, the change will decrease the net profit.
The final change is the liability for income taxes. This is deducted from the pretax profit to arrive at the final number, the net profit for the period.
Financial statements all use the same basic format. This makes it easier to compare results between companies and between years.
There are potentially dozens of indicators and ratios you can use to study the financial statements of a company. For the purpose of creating a basic starting point, focus here is on a very short list of fundamental indicators. These can be based strictly on the financial information you extract from the financial statements or, in one important exception, may combine financial and technical sides. This one exception is the price/earnings ratio (P/E). This is a comparison between the price per share and the reported earnings per share (EPS) reported most recently by the company.
The P/E ratio is a good place to start in exploring a range of fundamental indicators because it combines technical (price) with fundamental (earnings), and also because it matches dissimilar timing indicators.
Price is current, whereas earnings may be as much as three months in the past and not always reflective of what is going on today.
The P/E ratio combines technical (price) and fundamental (earnings) information to create a hybrid indicator.
Some analysts like to use forward P/E to analyze companies and their current earnings potential. This is a comparison between the current price and estimated earnings for the coming year.
The justification for the forward P/E is that it makes the indicator more current. However, a lot of change can take place in the future, and as an indicator of stock value, forward P/E is not a reliable one. Any indicator that includes estimates should be used only cautiously.
The forward P/E is a difficult indicator to rely upon, because it uses estimates in place of published results. The historical P/E is more reliable when studied over a 10-year period.
In calculating the historical P/E, the current share price is divided by the latest reported EPS, or earnings per share:
For example, if the latest reported price per share is $42.50 and the latest reported EPS was $2.85 per share, P/E (rounded up) is:
The operating statement provides the second area worth detailed analysis over several years. Just as you cannot make sound judgments about the current P/E ratio without studying the longer-term trend, you cannot truly appreciate the significance of the current revenue and earnings without seeing how the trend has moved over a decade.
Tracking revenue and earnings is not just a matter of making sure that the numbers rise every year. You look for true growth, meaning that the dollar value of revenues and the dollar value of net earnings both rise each year. But you also want to see net profits maintained at a consistent or growing percentage of revenues. Even when the dollar value of earnings rises, if the percentage is declining, that is a negative sign. It probably means that costs and expenses are outpacing the growth in revenue, and that is never a positive trend.
Referring to the two previously cited companies as examples of the trend in the P/E ratio, you can also track revenue and earnings trends over the same period.
The final major area worth analysis is working capital. This is the amount of cash available to pay for current expenses and to fund growth and dividend payments. In its most basic definition, working capital is the net of current assets minus current liabilities. But in a broader sense, it refers to the longer-term trend reflecting the company’s management of cash.
The best-known working capital test is called the current ratio. This is an indicator derived by dividing current assets by current liabilities. The outcome should be a positive value, meaning there are most liquid assets on hand that the company owes in the next 12 months. A current ratio of less than 1 is a sign of very weak cash management. The expectation of a current ratio of 2 or better means excellent cash management; but many well-managed companies maintains their current ratio somewhere between 1 and 2.
The current ratio is rounded to a whole number and one decimal place. For example, if a company reports current assets of $1,462,000 and current liabilities of $845,400, the current ratio is:
As with all fundamental tests, it makes sense to track the current ratio for a full year. For example, in the case of General Mills and Caterpillar, the current ratio over 10 years was:
Current ratio, 10 years
Both of these are consistent enough over time, although, in the case of GIS, the current ratio has often been below 1. However, the consistency in both companies is reassuring, if the analysis is limited to a study of only the current ratio. However, it is quite easy to manipulate this ratio by borrowing money and holding proceeds in cash. This raises the current asset level, but the offsetting liability is long-term and does not show up as a current liability (except the coming 12 months of debt service). This hides a potential problem: the rise of long-term debt. As long as the current ratio remains constant and is used as the sole test of working capital, this situation does not come to light.
The current ratio is the best-known test of working capital, but it does not tell the whole story. The real long-term trend can only be understood by studying both the current ratio and debt ratio.
With this in mind, a second test is needed. The debt ratio is a comparison between long-term debt and total capitalization. The debt ratio is a percentage, but it is normally expressed as a value to one rounded decimal place, without percentage signs.
For example, a company reports current long-term debt of $41,200,000 and stockholder’s equity of $98,600,000. Total capitalization is a combination of these two:
The debt ratio is found by dividing long-term debt by total capitalization. The debt ratio is:
This company is capitalized 29.5 percent by debt and 70.5 percent by equity. However, it is not the relative portion of debt or equity that is conclusive, since the levels of debt capitalization vary by industry. What is important is how the debt ratio changes over time. Whenever you see a growing debt ratio, it is a danger sign. The more long-term debt a company is obligated to repay, the worse future working capital will be. As a growing amount of annual earnings have to be paid to bondholders and noteholders in interest, less is left for payment of dividends to stockholders or to fund future expansion.
An analysis of General Mills and Caterpillar for the 10-year period ending in 2009 shows how the debt ratio evolved.
Debt ratio, 10 years
In the case of General Mills, the high debt ratio at the beginning of the period was troubling, especially considering that the current ratio was less than 1 for most of the period. However, the company cut its debt ratio by nearly one-half over the decade. Caterpillar, an industry in which high debt ratios are expected, maintained a consistent level with a sudden increase in 2008 and a surprising decline in 2009. However, the consistency of the company’s current ratio, coupled with the debt ratio history, indicates sound cash flow management and healthy working capital.
It is not the debt ratio in the current year that matters, but the long-term trend. When you see the debt ratio climbing every year, it spells trouble for future cash flow.
In addition to determining whether to buy stock in any one company, you also need to determine whether it makes sense to own stock directly, or to rely on management of a mutual fund to build a portfolio and to buy shares in the overall holdings of that fund. Alternatives: Stocks or Mutual Funds examines the role that mutual funds might play in your investment plan.