When you see that pile of dirty dishes in the sink, you probably feel a tinge of guilt telling you that you really should wash them. But you just might not be in the mood. And that same sense of reluctant obligation might also apply to your portfolio. You might own some individual stocks and realize you really should be analyzing their fundamentals, but other things just seem more interesting. So the annual reports and proxy statements just pile up.
Certainly, performing a complete financial analysis of a company takes time as you run through all the financial statements, calculate dozens of financial ratios and study the industry, just to name a few things. Fundamental analysis can take a bit of effort, seeing that Wall Street analysts and credit rating experts get paid to do this kind of thing all day long.
Just because you might not have time to do a complete financial analysis doesn’t mean you should let your financial dishes sit in the sink. This chapter will tell you what ten types of fundamental analysis you should always make time for. You’ll find out which types of fundamental analysis you should prioritize for when looking to dig into a company’s financials but have limited time. If you conduct these ten aspects of fundamental analysis, you will be well ahead of many investors who just blindly buy stocks on a whim.
1. Measuring How Much of a Company’s Earnings Are “Real”
If you’re not a full-time fundamental analyst, and you own more than a handful of stocks, it would be a full-time job to constantly monitor in real-time every bit of financial data you’ll want to be aware of.
So here it is. My suggestion on the one form of fundamental analysis you should never skip is the measurement of a company’s quality of earnings. As soon as you can get your hands on a company’s income statement and statement of cash flows, you want to make sure a company’s cash from operations is greater than or equal to its net income. When a company is generating cash flow, you have some proof the earnings are real, not just smoke and mirrors allowed by accounting.
Comparing a company’s cash from operations to its net income only takes a few moments. The payback for this small investment of time is huge. If you avoid investing in companies with weak cash flow relative to their net income, you may sidestep many bum investments or even outright frauds.
2. Considering How Much Cash the Company Has
It would be pretty rude to ask strangers you meet at a cocktail party how much money they have in their savings accounts. But you don’t have to worry about such etiquette when it comes to companies. Before you invest a dime in a company, you want to make sure you not only know how much companies have, but also what they owe. You should know:
- How much cash a company has on the balance sheet
- How much the company owes to lenders in the short term and long term
- How much cash a company generates.
Paying close attention to these four variables will help you avoid plunking your money down in a company that may not survive. Looking for a quick way to see if a company’s survival is in question? Don’t forget to calculate the company’s Altman’s Z-score.
3. Making Sure You Don’t Overpay
Investors are constantly surprised when they spend hours and hours analyzing a company’s fundamentals, only to buy a stock and still lose money. There are countless forces at work to determine a stock’s price. Remember, stock prices are set by the constant tug of war between buyers and sellers trading shares back and forth until settling on a price everyone can agree upon. And that’s why it’s critical for you to not only evaluate how solid a company is, but also how profitable it is and whether it has staying power. It’s imperative not to pay too much.
Studies have shown that growth stocks, or shares of companies with the highest valuations measured by price-to-book ratios, are often the biggest disappointments for investors. This means that the more you pay for a stock, the lower your future return is likely to be.
4. Evaluating the Management Team and Board Members
As an investor in a company’s common stock, or the shares issued to the public representing standard ownership in the company, you’re at the mercy of the management team to make the correct decisions with your money. And you’re counting on the board of directors to keep a watchful eye on the management team. If you can’t trust the management team and board of directors, you shouldn’t trust them with your investment.
If you don’t look at anything else in the proxy statement, always be sure to look for related party transactions between executives or board members and the company. These are side business dealings with the potential to corrupt the ability of executives or board members to represent the interests of investors like you. And even if a CEO is doing an excellent job, be watchful of excessive pay packages. CEOs that aren’t ashamed to lavish themselves with excessive pay probably aren’t afraid to take other liberties with your money.
5. Examining the Company’s Track Record of Paying Dividends
Day traders used to scoff at investors who paid attention to dividends. During stock market booms, these small cash payments some companies pay to their shareholders seem almost insignificant.
But fundamental analysts know better. For one thing, dividend payments account for a big portion, roughly 4 percent, of the returns generated by stocks over time. Miss out on those payments, and you’re leaving quite a bit of cash on the table. Also, steady dividends can make sure you’re earning
something on your money even if a stock is flat. Dividend payments can also be helpful in helping you decide how much a stock is worth.
Lastly, while companies can fudge or pad their earnings, dividends can’t be faked. Dividends are usually actual cash payments you can deposit in a bank account or spend. Companies paying dividends are at least showing you a tangible sign of their profitability.
6. Comparing the Company’s Promises with What It Delivers
It’s easy to simply take a company management’s word as gospel. Financial television is especially infamous for practically turning corporate CEOs into royalty and taking everything they say at face value.
That’s not to say you, as a fundamental analyst, need to treat CEOs as crooks or liars. But it is up to you to verify claims made by a CEO. If a company’s CEO says a new product is selling like crazy, take the time to look at its revenue growth and also the accounts receivable turnover in days to ensure customers are buying and actually paying for the goods. If a company claims to have posted record profits, it’s up to you to not only verify the claim, but also make sure it wasn’t the result of accounting puffery.
Always compare the promises made by a CEO in one year’s annual report to shareholders with the reality delivered in the following year’s financial statements. Professional fundamental analysts often read a company’s latest 10-K with the previous one, side-by-side.
7. Keeping a Close Eye on Industry Changes
Fundamental analysis is powerful, but there is a great deal of emphasis placed on financial statements. And the big weakness of financial statements is that they’re historical documents telling you how a company did, as opposed to how it will do.
Trend analysis is one way fundamental analysts look beyond historical numbers to assess the future. But you need to be especially mindful of game-changing technologies or new ways of doing things in business that can render a company’s way of making money, or business model, obsolete.
The constant danger that a new technology may wipe out a company is one reason why some fundamental analysts stick with easy-to-understand and basic businesses, where consumers keep coming back. Consumer products companies, for instance, don’t have to worry that people will stop buying deodorant (at least your nose hopes so).
8. Understanding Saturation: Knowing When a Company Gets Too Big
Eventually, for most companies, the early days of easy growth evaporate as the product and business matures. A product, which might have been so new that everyone had to buy one, eventually becomes so prevalent that growth slows. And when a company expands so much, it becomes more difficult to grow further. These growing pains and maturity present great challenges to both management teams and fundamental analysts. Companies often struggle with the transition from a fast-growth company to a slower growth one, and sometimes need to change their entire strategies. Fundamental analysts, too, much change the way they evaluate a company and measure its valuation.
Keep a close eye on a company’s operating profit margin, or how much of revenue the company keeps in profit after paying direct and indirect costs. When you see the operating profit margin deteriorate, that can be a heads-up that the business’ glory days are fading. That doesn’t mean you shouldn’t invest in a mature business. In fact, the contrary is often true. But you need to be aware
that the business’ fundamentals have changed.
9. Avoiding Blinders: Watching the Competition
It’s often tempting to buy stock in a company you think is the best in a business, and assume that your work is done. But companies are constantly changing and evolving. Sometimes a company’s rival might rise up from near death with a killer product and pose a huge threat. Meanwhile, the valuations of so-called leading stocks are often driven up so high that its future returns are often disappointing.
When looking to invest in a company, take the time to read statements and documents released by a rival company you might consider to be weaker. Paying attention to statements made by the CEO of a rival company in a letter to shareholders, for instance, might tip you off to industry trends the CEO of the leading company may not have noticed yet.
10. Watching Out When a Company Gets Overly Confident
Some athletes get themselves into trouble when they decide to showboat. The temptation to do that one extra and unnecessary back flip or victory dance sometimes lets a quiet competitor sneak up and steal the win. Companies, too, can sometimes get full of themselves. Figuring that their fat days will never end, some companies build opulent headquarters, send employees on overly lavish business trips or even spend cash on vanity promotions.
Perhaps one of the ultimate forms of business vanity is when a company pays millions of dollars for the right to slap its name on a professional sports team’s stadium. During the 1990s, it became fashionable for companies to pony up millions of dollars to sponsor venues hosting a professional team in sports including football, baseball and basketball. Several academic studies, though, have shown there to be very little to no benefit to companies, on average, for making these large investments. One of these studies lists a number of the classic examples of companies that ran into extreme financial difficulty after paying to put their names on sport facilities, including Adelphia, Enron and PSINet, which all filed for bankruptcy protection.
Source: Fundamental Analysis For Dummies