Fundamental analysis –
Part I
Chapter 12
Overview of fundamental analysis

Fundamental analysis attempts to use publicly available information to
evaluate securities in an attempt to measure the security’s intrinsic value.

Fundamental analysts (sometimes called value investors) try to answer the
question:

“What is this security actually worth?”
Five factors for fundamental analysis
1.
Overall economic conditions – These include factors such as the
overall economic environment of the countries or regions important to
the security.
2.
The firm’s management – Fundamental analysts will make efforts to
ensure that a firm’s management is experienced, stable, and honest.
3.
The firm’s financial performance – How does the firm make money. In
addition, they want to understand how profitable a firm is and establish
criteria to estimate the company’s growth prospects.
4.
The firm’s financial position – Does the firm have sufficient resources
to protect itself in a downturn and to invest in itself for the future.
5.
Valuation – Adding complexity to the investing decision is the fact that
there is a difference between a good company and a good stock.
Valuing a firm is important to ensure that the analyst doesn’t pay too
much for the security.
Where to find information needed for
fundamental analysis

The Securities and Exchange Commission provides updated and historical
filings for every publicly-traded company on its EDGAR database found on the
SEC’s website (sec.gov).

www.sec.gov/edgar/searchedgar/companysearch.html
A firm’s earnings release


Publicly-traded firms will hold an earnings press release every quarter.

Conference call – not required but popular

Earnings guidance – also not required

8-K – report of events and changes

10-Q – quarterly release of financial statements

10-K – year-end release (comprehensive)
Transparency – the ability of investors to have access to a firm’s financial
information
Key areas of the 10-K

The firm’s financial statements – These statements provide insight into the
firm’s performance and health.

Management discussion and analysis (MD&A) –Look at the firm’s performance
from management’s perspective.

Risk factors – Lists every actual and potential risk that they see in the market.


Particularly large red flags are “new” risks that were not in previous reports. In
addition, if management describes a threat as “material”, then they deem it to be
an extremely serious threat.
Changes in and disagreements with accountants on accounting and financial
disclosure – In some cases, a firm will change the way it accounts for some
item or items.

In some instances, changes can raise a red flag. In addition, in rare instances, this
section may even detail how the firm’s management and the firm’s accountants
disagree on the financial report. This is a larger red flag.
Often overlooked in the 10-K

Footnotes – May contain more useful information than the statements
themselves.


For instance, a firm’s debt is described in detail in the footnotes. Do they have
good terms? You may also find “off-balance-sheet” items that (in some cases) may
be a red flag. For instance, before declaring bankruptcy, Enron hid numerous ruses
by simply footnoting them as off-balance-sheet entities.
Auditor’s opinion – The firm must hire an outside accountant (auditor) to sign
off that the numbers appear to be correct. In this section, the auditor will
indicate any issues that might cause readers to potentially misinterpret any
information in the filing.

If an auditor ever uses the term, “going-concern” – this is a considerable red flag!
The auditor thinks the firm is going bankrupt! In addition, if a firm changes
auditors, you may want to do some more investigating to understand why.
10-K vs. Annual report

The firm’s annual report is an annual publication provided to shareholders
that describes the year’s operations and financial performance.

Will contain much of the same information provided in the 10-K, but with
significantly more “marketing” material.

Generally available on the firm’s website.
Getting started using a top-down
fundamental analysis

We will be using the “top-down” approach to fundamental analysis.

Only after the economy has been assessed, does the top-down investor begin
to explore specific firms.

The macro-economy
Assessing the overall economic
conditions

The macro-economy – How is the overall economy doing?

The business cycle –In what stage of the business cycle is the economy in?
Is the economy growing or retracting – at a top or near the bottom?

Industry analysis – What is the economic data suggesting about the future
prospects of different industries/sectors?
Macro indicators

Gross domestic product (GDP) – Gross domestic product is a measure (in
monetary value) of the economy’s total production of goods and services over
a specific time period.

Interest rates – Recall from Chapter 5 the importance that interest rates have
on the overall economy. For firms that finance operations through borrowing,
higher rates may serve to reduce the attractiveness of projects (slowing a
firm’s growth) or reduce the profit enjoyed from current operations (lowering
earnings).

Unemployment rate – The unemployment rate is the percentage of the total
labor force that is seeking employment, but cannot find it. When
unemployment rates increase, consumers usually decrease both their
spending and investing

Inflation – Recall from Chapter 5 that as the prices of goods and services rise,
purchasing power falls. A company’s returns can sometimes be overstated in
high inflationary environments due simply to the inflation (and not growth).
More macro indicators
Economic Indicators
Indicator
Source
Auto & truck sales
Business inventories
Consumer confidence
Consumer credit
Consumer price index (CPI)
Durable goods orders
Existing home sales
Gross domestic product (GDP)
Housing starts
Industrial production
Initial jobless claims
Money supply
New home sales
Producer price index (PPI)
Unemployment
Department of Commerce
Department of Commerce
Conference Board
Federal Reserve
Bureau of Labor Statistics
Department of Commerce
National Association of Realtors
Department of Commerce
Department of Commerce
Federal Reserve
Department of Labor
Federal Reserve
Department of Commerce
Bureau of Labor Statistics
Bureau of Labor Statistics
Tying to investments

Economic activity tends to change in relatively predictable patterns,
known as the business cycle.
GDP output at different stages of the
business cycle
Peak
Expansion
Contraction
Trough
Cyclical vs defensive

Cyclical sectors tend to be extremely sensitive to business cycle changes.


Defensive sectors are much less sensitive to changes in the business cycle.


Example: Automobiles - Consumers typically only make large purchases (like a new car)
when times are good. Automobile manufacturers oftentimes enjoy tremendous growth
in up markets but they tend to suffer larger-than-average losses in down markets.
Example: Medication - Consumers tend to buy their medication no-matter-what, but
they do not increase their buying in an expansion.
Sector rotation describes the re-allocation of assets based on the stage of the
business cycle. In essence, when times are good, analysts allocate more heavily to
cyclical sectors, and when times are hard, analysts allocate more heavily to
defensive sectors.
Possible sector rotation strategies for
the stages of the business cycle
Approaching a peak Materials, Industrial goods
Following a peak
Health care, Consumer staples
Approaching a trough Financials, Utilities
Following a trough
Consumer discretionary, Technology
Assessing management

Recall from Chapter 4 that the proxy statement is a document provided to
shareholders that describes issues to be voted upon at the next shareholder’s
meeting.

In addition, the proxy provides tremendous insight into a firm’s management
and board of directors.
Proxy statement topics

Management’s experience: There are detailed biographies and resumes for the management team of the
firm on the proxy statement.

The board of directors: Be wary of boards made up with “busy” people. For instance, if they are the CEO
of their own firm and serve on numerous other boards, they likely do not have time to dedicate to the
service of this board.

Compensation: In many cases, the compensation is not straightforward. For instance, it may be listed as a
percentage of sales increases or some other metric. For the investor, preferable compensation packages
will be linked to a firm’s cash flow or operating profit (perhaps as out-of-the-money call options). Also, be
sure that you understand the compensation listed as “Other”. While it may be fine, if there is abuse, it is
likely to take place here.

Conflicts of interest: If someone on the board has a conflict of interest (perhaps another business
relationship with the firm), then this is disclosed in the proxy.

Ownership details: The executives of the company will spell out in the proxy if they own the firm’s stock
or not. If executives own shares of the company stock, this means that their interests should be aligned
with your (shareholder) interests.

Views of other investors: If you view the proxy, you can see if any of these shareholder proposals are
worrisome to you as a potential stockholder.
Analyzing financial statements

No fundamental analysis is complete without a thorough review of the firm’s
financial statements.

The goals of Generally Accepted Accounting Principles (GAAP) are to make
financial accounting “relevant, reliable, consistent and comparable”.

While these goals sound helpful, they are sometimes contradictory.

Regardless, it is possible to analyze financial statements without an advanced
knowledge of accounting.
Income statement

The income statement provides you with insight into just how well the
company is doing.

Revenue – Cost of goods sold – Operating expenses + Other income – Other
expenses – Interest expense – Taxes = Net income
Income statement example
Roxxon Corporation - Income statement
31-Dec
This year
31-Dec
Last year
31-Dec
Two years ago
Total revenue
1,180,000
825,000
700,000
Cost of revenue
800,000
675,000
721,000
Gross profit
380,000
150,000
(21,000)
Operating expenses
R&D
Selling & administrative
Other
775,000
850,000
-
1,500,000
2,000,000
-
685,000
2,400,000
-
1,625,000
3,500,000
3,085,000
(1,245,000)
(3,350,000)
(3,106,000)
Total operating expenses
Operating income (or loss)
Total other income/expenses - Net
Earnings before interest and taxes
Interest expense
Tax expense
Net income
16,000
(1,261,000)
4,000
17,700
(3,367,700)
3,400
(1,265,000)
1,300
(3,107,300)
1,400
-
(3,371,100)
(3,108,700)
Using comparisons

Only a minimal amount of information can be discerned from a single period.

In order for the numbers to begin to provide you with insight you need to
compare a company’s most recent period’s results with:

Itself - In order to understand a company’s current performance, you must
compare today’s results with results from prior years. When comparing this year’s
income statement to prior years’, look for trends.

The industry/competitors – Recall that to adequately access a stock’s return over
some time period, it must be compared to the returns of an index (preferably an
index of its peers). Why stop at the return? This same comparison can be made
for many aspects of the firm.
Common-sizing
For example: Assume that you are looking at the operating expenses on the income statement of a firm
and note the following:
Operating expenses

Most recent year =
$5,000

Prior year =
$4,500

Two years ago =
$4,000
By only looking at the expenses, they appear to be increasing. This is a red flag! However, assume
when you look at the firm’s revenues, you see the following over the past three years:
Revenues

Most recent year =
$20,000

Prior year =
$15,000

Two years ago =
$10,000
Common-sizing

If you common-size the operating expense as a percentage of sales, you now see
the following trend:
Common-sized operating expenses

Most recent year =
$5,000/$20,000 = 25%

Prior year =
$4,500/$15,000 = 30%

Two years ago =
$4,000/$10,000 = 40%
Upon common-sizing the item, you can more easily see that operating expenses have
actually been falling as a percentage of sales. A potential red flag without commonsizing is actually a reassuring trend with common-sizing! Almost without exception,
common-sized results are more descriptive and useful to you as an investor.
Finding the earnings per share

As a potential stock investor, perhaps one of the more important
considerations is what your ownership entitles you to receive.

Earnings per share (EPS) tells you how much of the firm’s net income that is
technically “yours” as the owner of a share.

EPS = Net income / # shares outstanding

Diluted EPS = Net income / # shares that could be outstanding
Balance sheet

While the income statement provides insight into the performance and
profitability of the firm, the balance sheet shows you a snapshot of the firm’s
financial health.

Assets – items the company owns

Liabilities – items the company owes

Stockholder’s equity – items left over after subtracting liabilities from assets

Assets = Liabilities + Equity
Balance sheet
example
InGen Inc. - Balance sheet
PERIOD ENDING
31-Dec
This year
31-Dec
Last year
31-Dec
Two years ago
Assets
Current assets
Cash & cash equivalents
Accounts receivable
Inventory
180,000
350,000
-
130,000
280,000
-
100,000
245,000
-
Long-term assets
PP&E
Intangible assets
Other assets
1,410,000
225,000
45,000
1,365,000
215,000
38,000
1,360,000
210,000
6,500
Total assets
2,210,000
2,028,000
1,921,500
31,000
4,800
3,000
71,000
5,200
7,000
79,000
6,400
10,000
Long-term liabilities
Long-term debt
Other liabilities
225,000
95,000
228,000
83,000
231,000
86,000
Total liabilities
358,800
394,200
412,400
1,000,000
851,200
-
1,000,000
633,800
-
1,000,000
509,100
-
1,851,200
1,633,800
1,509,100
Liabilities
Current liabilities
Accounts payable
Short-term debt
Other current liabilities
Stockholder's equity
Preferred stock
Common stock
Retained earnings
Capital surplus
Total stockholder's equity
Common-sizing
InGen Inc. - Balance sheet - Common-sized
31-Dec
This year
31-Dec
Last year
31-Dec
Two years ago
Current assets
Cash & cash equivalents
Accounts receivable
Inventory
8%
16%
0%
6%
14%
0%
5%
13%
0%
Long-term assets
PP&E
Intangible assets
Other assets
64%
10%
2.0%
67%
11%
1.9%
71%
11%
0.3%
Total assets
100%
100%
100%
Current liabilities
Accounts payable
Short-term debt
Other current liabilities
1%
0%
0%
4%
0%
0%
4%
0%
1%
Long-term liabilities
Long-term debt
Other liabilities
10%
4%
11%
4%
12%
4%
Total liabilities
16%
19%
21%
0%
45%
39%
0%
0%
49%
31%
0%
0%
52%
26%
0%
84%
81%
79%
PERIOD ENDING
Assets
Divide each type of asset by total assets
Divide each type of liability by total
liabilities + equity
Divide each equity category by total
liabilities + equity
Insights:
The firm is primarily financed by equity
investment
AR increasing… red flag?
The firm possibly has low liquidity (compare
cash to PP&E)
Liabilities
Stockholder's equity
Preferred stock
Common stock
Retained earnings
Capital surplus
Total stockholder's equity
Working capital

A healthy company has funds to withstand downturns in the economy and
invest for its future. One quick calculation that you can perform to gain
better insight into a company’s health is working capital.


Working capital = Current assets - Current liabilities
For example: In order to calculate the working capital in the most recent
year for InGen Inc (Figure 12.3), simply subtract current liabilities
($38,800) from current assets ($530,000) to obtain the firm’s working
capital of $491,200.

Positive working capital is good, low (or negative) working capital implies the
firm may have trouble meeting its ST debts (especially if it falls on hard
times).
Dilution

If a firm issues too many shares, then this can have a negative impact on your
return potential (dilution).


If this number of shares outstanding begins to rise (due to executed stock options,
mergers, etc.), it is a red flag.
On the other hand, some firms combat dilution by buying back their own
firm’s shares. In a stock buyback, a company will purchase their own shares
off the market and put the shares into the firm’s “Treasury stock”.

You can also see if a firm is buying back stock on the Cash Flow Statement…
Statement of cash flow

The cash flow statement tracks and reports a firm’s cash inflows and outflows only.


If a firm is “owed” money – it doesn’t show up on the cash flow statement. Only cash that is
received is an inflow and only money that physically leaves the firm’s account is listed as an
outflow.
The statement tracks a firm’s cash by breaking up the firm’s cash flow into three separate
categories:

Operating activities – cash generated or reduced from a company’s core business activity

Investing activities – cash generated or reduced as the company upgrades and re-invests
money back into the business

Financing activities – cash generated or reduced from transactions with lenders and/or
investors
Statement of cash flow example
Weyland-Yutani Corporation - Cash flow
PERIOD ENDING
Net income
31-Dec
This year
2,000
31-Dec
Last year
31-Dec
Two years ago
1,910
1,749
1,237
(31)
53
(13)
(394)
1,080
85
5
(7)
5
1282
(64)
82
(7)
23
2,852
3,078
3,065
Operating activities, cash flows provided by or used in
Depreciation
Changes in accounts receivables
Changes in liabilities
Changes in inventories
Changes in operating activities
Total cash flow from operating activities
Investing activities, cash flows provided by or used in
Capital expenditures
Investments
Other cash flows from investing activities
(2,118)
2
114
(1,971)
(67)
144
(2,241)
55
192
Total cash flow from investing activities
(2,002)
(1,894)
(1,994)
Financing activities, cash flows provided by or used in
Dividends paid
Sale/purchase of stock
Net borrowing
Other cash flows from financing activities
(687)
(188)
(445)
-
(637)
(496)
739
-
(624)
(1,199)
1,129
-
Total cash flow from financing activities
(1,320)
(394)
(694)
790
377
Changes in cash and cash equivalents
(470)
Operating activities

Depreciation indicates the wear and tear that takes place on tangible assets.
Depreciation must be accounted for – but it doesn’t directly impact a firm’s
cash.

Other operating activities:

Changes in accounts receivable

Changes in liabilities

Changes in inventories
Investing activities

The most notable investing activity for most firms is the capital expenditures
(capex) activity, which are the funds that the firm reinvests within the firm.

Capital expenditures are oftentimes a significant cash outlay for the firm, but
in most cases, as an investor, you want to see that the firm is spending money
to keep itself up-to-date.
Financing activities

In the simplest terms, a company’s cash increases when it borrows money or
sells stock, and its cash will decrease when it pays down loans and pays out
money to shareholders (usually in the form of dividends).
Monitoring cash flow
(earnings quality)

As an investor, you want to know that the firm’s earnings are due to increased
sales and lower costs.

If total cash flow from operating activities ≥ net income, then the firm’s earnings
are high quality.

If total cash flow from operating activities < net income, then the firm’s earnings
are low quality.
Free cash flow

A company’s free cash flow is basically the amount of cash that the firm
produces in its normal course of doing business. However, free cash flow can
be negative. Rather than produce cash, some companies exhaust it!

Free cash flow = cash flow from operating activities – capital expenditures
If free cash flow is negative

If you have determined that a firm is utilizing more cash than it is generating,
then you can perform a quick calculation to help you determine how long the
company has before it depletes its cash reserves (its survival period).

Survival period = Liquid assets / (Free cash flow)