The Basics of Fundamental Analysis
By Andrew Greta
Special To TheStreet.com
12/23/98 9:53 AM ET
As the market relentlessly calls into question virtually every portion of your
stock portfolio, even the most independent-minded investor can start doubting
himself. You wonder, did I make the right decisions when I bought these
stocks? To answer yourself in any rational fashion, you need to be able to
judge whether circumstances, not just psychology, have changed for your
holdings. In times like these, strong fundamental analysis becomes key to
your conviction. TSC has developed a five-day series on the how-to of
fundamental analysis: what it is, how to read a balance sheet, and how to
read an income statement.
Part 1: Introduction to Fundamental Analysis
Part 2: Dissecting a Balance Sheet
Part 3: Dissecting the Income Statement
Part 4: Is BUD a Buy?
Part 5: Reader Q&A from the Week's Mailbag
Part 1: Introduction to Fundamental Analysis
By Andrew Greta
Special to TheStreet.com
12/23/98 2:11 PM ET
As the market relentlessly calls into question virtually every portion of your
stock portfolio, even the most independent-minded investor can start doubting
himself. You wonder, did I make the right decisions when I bought these
stocks? To answer yourself in any rational fashion, you need to be able to
judge whether circumstances, not just psychology, have changed for your
holdings.
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In times like these, strong fundamental analysis becomes key to your
conviction. With this in mind, welcome to our five-part series on the how-to of
fundamental analysis: what it is, how to read a balance sheet, and how to
read an income statement.
As the pundits rant about Russia, rate cuts, devaluation and deflation, you're
probably looking at your now-droopy portfolio thinking, "This is the same
bunch of stocks I owned happily a month ago. How did the world get so ugly
so fast?"
It's a good question, because chances are your companies haven't changed
much. It's investor psychology that has.
You could try to chase that psychology by day trading. Or you could opt out of
the daily grind altogether, on the theory that you know your companies'
prospects as well or better than anyone. In the long run you'll be vindicated.
Psychology dissipates, fundamentals endure.
The Internet -- long hailed as a day-trader's dream -- actually provides the
weapons investors need to do serious company analysis. Sure, the Net can
give traders the unprecedented ability to skim teenies off the volatility du jour
from the comfort of their living room. But it also provides investors with nearly
unlimited access to the financial data needed for fundamental analysis of a
company's future.
To understand the difference between pure fundamental analysis a la Warren
Buffett and its day-trading cousin, technical analysis, think of the market as an
open-air bazaar with stocks as items for sale. A technical analyst would wade
into the shopping frenzy with eyes seeking the crowd. He would ignore the
goods for sale altogether.
When the trader notices a group gathering in front of the booth peddling, say,
cookware, he'd scramble over to buy as much inventory as possible, betting
that the ensuing demand would push prices higher. The trader doesn't even
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care what a cast iron skillet is as long as some "greater fool" at the back of the
line is willing to buy it for more than the trader paid.
The fundamentalist, on the other hand, takes a more sedate approach. The
fundamentalist's eyes would be solely on the products before him. He would
dismiss the other shoppers as an emotional herd of fools who couldn't tell a
good deal if one slapped them in the face. Once the crowd dissipated from the
cookware booth, he might casually wander over to examine the wares.
First the fundamentalist might try to assess the value of the metal contained in
a particular skillet if melted down and sold as scrap in order to establish a
base price for the object. In the stock market this might be something like
figuring out the book value or liquidation price of a company.
Next, the fundamentalist would probably take a close look at the quality of the
workmanship to see if it's going to hold up over time or crack on its first use,
just like a stock analyst checks a company's balance sheet for financial
soundness.
Then, he might try to get a handle of the productive capabilities of the skillet in
terms of meals cooked or people fed in a manner akin to forecasting future
earnings from a company's income statement.
Finally, the fundamentalist would combine all of the data on the asset to come
up with an "intrinsic value," or a value contained in the object itself
independent of the market price. If the market price were below the intrinsic
value, the fundamentalist would buy it. If above, the fundamentalist would
either sell the skillet he already owned or wait for a better deal.
Fundamental analysis is a lot more work, but therein lies its appeal. Crowd
psychology can be a powerful yet fickle force in the markets. As a technician,
you've got to stay constantly alert or risk getting trampled under feet when the
herd reverses direction, as it has lately.
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Diving in up to your elbows in the guts of some company to diagnose its
prospects, on the other hand, takes the kind of surgical skill and diligence that
many traders would just as soon bypass on their way to the rush of more
instant chiropractic gratification. As a fundamentalist, however, when you
finally do buy a stock that represents a good value, you largely insulate
yourself from the day-to-day whimsy of human impulse in favor of longer-term
results.
The intrinsic value approach to the markets is based on a couple of big
assumptions. The first is that the intrinsic value of an asset can differ from its
market price. Purists of the "efficient market hypothesis" find this concept
ridiculous. They feel that market price is the only reflection of true value for an
asset and reflects all information available about its future prospects at any
point in time.
Detractors say the efficiency theory might hold in an ideal laboratory setting.
But go out in the real world and things get a little sticky. Information flows get
delayed, altered or incompletely disseminated. And more importantly, human
beings act on their personal, often illogical, perceptions about the world
around them. How else can you explain events like Holland's classic 17th
century tulip fiasco where citizens delirious with speculative fever bid prices
for single bulbs up to an equivalent of $40,000 today? Or, more recently, the
Netscape (NSCP:Nasdaq - news) IPO where traders paid $70 per share or
more for a company that has barely showed positive income to this day?
Assuming you accept the notion of intrinsic value, the second big assumption
of fundamental analysis is that, even though things get out of whack from time
to time, the market price of an asset will gravitate toward its true value
eventually. Again, probably a safe bet considering the long upward march of
quality stocks in general despite regular setbacks and periods of irrational
exuberance. The key strategy for the fundamentalist is to buy when prices are
at or below this intrinsic value and sell when they get overpriced.
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Figuring out the fair value of a company is the tough part. There are no magic
formulas, and a complete understanding of the entire process could take an
entire career to develop (and for some analysts, it seems that two lifetimes
wouldn't be enough). For the beginning investor not inclined to do
fundamental research, it pays to rely heavily on professional sources like
Value Line, S&P stock reports (www.personalwealth.com), and research
reports from a broker to get a good fundamental picture of a given company.
Why go it alone when there are drones out there who've already done much
of the work for you?
That said, there's still a lot that the individual investor can learn about the
fundamental process in terms of understanding an analyst's methodology,
terminology, and key indicators, that can make you a more confident
consumer of financial information and hopefully a better investor to boot.
We're tackling some of these issues and presenting them to you in a form that
should help increase your investing skills.
In part two, we take a look at reading balance sheets: where to find them,
what they mean, and what key figures you should look at when analyzing a
company. Then, in our third installment, we cover the basics of income
statement analysis. In the fourth segment, we pull it all together, and review
some good sources for extra reading.
Finally, we wrap the series up with an ongoing Q&A to address any specific reader
questions. While we can't give you an MBA's worth of financial analysis, we can go a
long way toward removing some of the mystery surrounding the process.Part 2:
Dissecting a Balance Sheet
By Andrew Greta
Special to TheStreet.com
12/23/98 5:03 PM ETIf a company were a building, the balance sheet would be
the blueprint showing the financial framework of the business. The sheet is
divided into three sections:
Assets: What the company owns.
Liabilities: What the company owes.
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Shareholder's Equity:: Essentially the "net worth" of the company.
If you think about the divisions in terms of personal finance, assets are all the
things you own, like your house, car, bass boat, stocks or collection of Lady Di
commemorative china plates.
Your liabilities are any loans you have outstanding, like your mortgage, credit
cards or that 10 bucks you owe your buddy for lunch last week.
The difference between your assets and liabilities is your net worth, or
whatever is left after you sell all your stuff and pay off all of your debt.
The three sections of a balance sheet are usually displayed like the graphic to
the right.
The format reflects the condition that the two sides of the balance sheet must
equal each other. Or, as every accountant has tattooed on the backs of their
eyelids:
Assets = Liabilities + Shareholder's Equity
Sources of Data
Getting balance sheets for your favorite companies is like finding bagels in
Manhattan -- people will practically throw them at you. If you don't feel like
ordering a free annual report or financial statement from the firm's investorrelations department, just log on to FreeEdgar . Not only does the site sport
up-to-date figures straight from the SEC, it offers a really slick free optional
plug-in that allows you to download reports directly into your Excel
spreadsheet for further analysis (something that'll come in handy later).
Just look for the 10-K (annual financials) or 10-Q (for the most recent quarter).
Usually, balance sheets only list two years' worth of data, so download two or
three reports from past years to give some meaningful trend information for
comparison. For my examples, I'll be using Anheuser Busch (BUD:NYSE news), a fairly predictable blue-chip with a simple product line -- beer. So I
downloaded the '97 and '95 10-Ks to get four years of stats.
6
Overview
Assets are listed in descending order of liquidity (cash first, buildings and
machinery last). The same goes for liabilities (accounts payable first with longterm debt bringing up the rear). Anything collectible in the short term (usually
under one year) is considered a "current" asset, while anything owed by the
company in the same time frame is a current liability.
You can tell a lot about the makeup of a company just by thinking logically
about the numbers as a whole (a classic B-school hazing ritual includes
figuring out the industry of an
anonymous company just by
studying the balance sheet). A
brief tour of BUD's financial
structure shows that its "Plant
and Equipment" accounts for
a whopping $7.75 billion of the
$11.72 billion in total assets.
This makes sense since
canning 80 million barrels of
fermented grain per year requires some pretty big vats and not much else. A
bank, on the other hand, will probably show outstanding loans as its biggest
asset, while a mail-order computer reseller might show high product
inventories. The bottom line is that the assets should fit with the company's
business. If something seems out of whack, compare it with other firms in the
same industry to see what's going on.
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Next, check to see how the assets are financed (or "capitalized") by looking at
the right side of the balance sheet -- the liabilities and shareholder equity
section. In BUD's case, long-term debt in the form of bonds makes up a fairly
substantial part of the firm's capitalization, at around $4 billion. Since the risk
on hard assets like buildings and machinery is relatively low and their lifetimes
are long, borrowing money from bond investors for, say, 30 years is an
inexpensive way for the company to pay off the assets throughout their
productive life. Again, a good
fit.
On the other hand, if a
company finances
substantial long-term assets
with mostly short-term debt,
watch out. A one-year bond
might seem like a good deal
for the company at, say, 5% interest, but if conditions change and it's forced to
renew the loan at 7% next year, those extra interest payments could easily
total in the millions for a big loan.
Since you can't just pawn off $1 billion worth of brewing equipment at your
corner flea market, those increased loan payments could financially strap the
company and land it in bankruptcy faster than you can say rate hike. Longterm bonds, on the other hand, may seem more expensive at first, but the rate
is locked in over a long time frame, so they're a much more predictable liability
-- perfect for financing big, illiquid assets.
Working Capital and the Current Ratio
When you pay your phone bill or buy a hot dog, you do it with money that
you've got on hand to meet living expenses.
The same goes for corporations. The current
liabilities of a company (like accounts payable
and short-term loans) get paid with current
assets (like cash, or accounts receivable). The
difference between the ready funds of a
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company (current assets) and what they owe in the short-term (current
liabilities) is called "net working capital."
Just like your own personal savings cushion, the amount of net working
capital that a company employs largely determines its ability to pay bills, meet
payroll, finance growth of operations and capitalize on new opportunities.
Companies that fail to keep an adequate buffer are like folks that constantly
overspend and rack up credit card bills they have no hope of paying off.
Sooner or later, the situation catches up with them and they've got armed
goons on their doorstep repossessing the TV -- not exactly a situation that
makes for a profitable investment.
So how big of a cushion is enough? First, divide the total current assets by the
current liabilities to get the "current asset ratio." Most pundits claim that a ratio
of 2.0 (twice as many current assets as current liabilities) is a good
benchmark, but it depends on the business. High-growth companies need a
larger cushion to finance rapid expansion, while big, established firms can get
away with less.
BUD rings in at a scant 1.06 compared with its competitor, Coors
(ACCOB:Nasdaq - news), at 1.44. This difference could be an indicator of
BUD's future growth prospects -- or lack thereof -- since they don't really have
the free bucks needed to go on a major shopping spree and expand
operations into new markets.
But more importantly, take a look at the current ratio trend over time. (This is
one place where an Excel spreadsheet can facilitate your analysis.) A low, but
stable current ratio like BUD's is less of a problem than a sharply declining
ratio that might signal either unsustainable growth or a deteriorating business.
Both conditions are serious red flags for any investor.
Price-to-Book Value
In accounting terms, assets are recorded on the balance sheet at "book
value" (the original cost of an asset minus any depreciation over time).
Although the figures don't always match with the actual market value of a
particular asset at a given time, the book value of a firm is often used to give a
baseline worth if a company were simply liquidated and the pieces sold off.
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This book value is pretty much synonymous with shareholder's equity and is
totaled up for you on the bottom of the balance sheet. In BUD's case, the
book value was $4.04 billion in 1997.
Next, find the number of shares outstanding by pulling the figure out of the
financial footnotes (often listed under separate tables on FreeEdgar), or just
cheat and look it up on RapidResearch.com . Dividing BUD's book value by
the number of shares outstanding at 487 million, we get a book value per
share of $8.30.
Right away, you're probably thinking, "Hey, that's way less than the market
price of the stock on the Big Board in the high 40s," and you're 100% correct.
The excess above market price is viewed as the amount management has
increased the value of the company through prudent deployment of its assets,
and can vary greatly across industries.
Generally, however, the lower the price-to-book value relative to the rest of
the industry, the greater the stock's growth potential if the existing
management gets replaced or gets whipped into shape, and the greater the
likelihood the firm will get bought out by a competitor. Both are potentially
positive events for shareholders.
To compare book values of different firms, first divide the market price of the
stock by the book value per share to get the price-to-book ratio. In BUD's
case, the number was 5.3 at the end of '97 compared with Coors, at a measly
1.66. And BUD's figure is twice as high as the industry average, according to
RapidResearch.com. So far, BUD isn't shaping up to look like much of a value
compared to other alternatives.
Debt-to-Equity Ratio
Dividing the amount of long-term debt of a firm by its shareholder's equity
yields the debt-to-equity ratio, which gives some insight into how the firm is
capitalized. Again, the figure can vary greatly across industries. Because
interest payments on bonds are tax deductible to the corporation while
dividends to shareholders are fully taxed, companies have an incentive to
carry at least some debt on their books.
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However, getting overloaded with debt reduces management's flexibility and
increases the risk to shareholders. Companies way above the industry debt
average might be a source of concern while those well below might be buying
opportunities.
BUD had a debt-to-equity ratio of 1.08 at the end of 1997 ($4.37 billion in
long-term debt divided by $4.04 billion in shareholder's equity), well above the
industry average and competitor Coors, at 0.20. Some ardent value-oriented
investors -- including Ben Graham, co-author of the now classic Securities
Analysis -- say to avoid any stocks with a debt-to-equity ratio above 1.0. The
basic belief is that it's not prudent to owe more than you own.
Summary
The beginner's trip through the balance sheet might look something like this:
 Overview: Does the overall financial structure of the company make sense
for its industry? If not, compare it to other companies to find out what's going
on.
 Current Ratio: Over 2.0 or in line with industry averages and stable over time gets
a thumbs up; relatively low and declining gets a big thumbs down.
 Price-to-Book Value: In line with the industry average is neutral; significantly
higher suggests the stock is overvalued; significantly lower (or even less than 1.0)
indicates an undervalued opportunity.
 Debt-to-Equity Ratio: Strict value adherents only buy companies with a ratio
under 1.0; others are content if the figure is within industry averages.
By now, a basic picture of how fundamental analysts evaluate the structure of
a company should be starting to emerge. If it seems just as much art as it is
science, you're getting the point.
The work is hard, but the rewards are substantial -- both personally, in terms
of broadening your own foundation of investment knowledge, and financially,
when you discover the next market gem based on solid facts and diligent
research. (OK, that might sound a little highfalutin, but I'm trying to keep your
interest!)
In the next part, we'll dissect the income statement, where we use earnings to
answer the central question of fundamental analysis: What's a company really
worth?
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Part 3: Dissecting the Income Statement
By Andrew Greta Special to TheStreet.com 12/23/98 5:12 PM ET
While the balance sheet is like a snapshot of a company's financial structure
at a specific point in time, the income statement is more like a motion picture
showing the firm's operating activities for an entire year.
The balance sheet can show how financially sound a company is. The income
statement can answer every investor's central question: "How much money
are they making?" Even more important, the income statement can provide a
solid basis for forecasting future profits.
Here, more than anywhere, one-year figures are all but worthless in predicting
future performance. Since most income statements include three years of
information, it's best to download at least two from freeedgar.com or your
favorite info source.
For my examples, I imported the 10-Ks from Anheuser-Busch (BUD:NYSE news) from 1997 and 1994 directly into my Excel spreadsheet to get a full six
years of data in an easily handled format.
Overview
Understanding the layout of an income statement is a fairly intuitive process.
After starting at the top with "sales" or "gross revenue" (whatever the main
source of income is for the firm), the company subtracts out itemized
expenses to get to a final net income (or loss) for the year. Think of it like
getting your paycheck and then deducting taxes, rent, living expenses and
insurance. The amount left over is your discretionary income or profit for the
month.
One big difference between you and the firm (other than that they deal in
millions rather than thousands) is that the term "income" doesn't necessarily
refer to cash in hand. The accrual rules of accounting state that a firm can
record income when it sells goods or services regardless of when payment is
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actually received. In addition, expenses are recorded at the time the
purchased asset is actually used.
If, for example, a firm bought a five-year insurance policy at the beginning of
1998 for $10,000, it would record only $2,000 per year as an insurance
expense until the policy expires, instead of expensing the entire 10 grand up
front.
It's kind of a technical distinction but an important one, since a company with
positive earnings on the income statement can still go bankrupt if it doesn't
have enough cash on hand to meet day-to-day needs. That's why checking
the balance sheet for sufficient working capital through the "current asset"
ratio as described in part two is so critical.
EPS Growth
Assuming the firm checks out for reasonable financial soundness (again, see
the prior discussion of the balance sheet), turn your
attention to the bottom line of the sheet called
"earnings per share" to see how the company
stacks up over several years of performance. This
figure represents the total net income divided by the
number of shares the firm has issued. Think of it as
your share of the corporation's overall profit if it paid everything out to the
stockholders and kept nothing to reinvest in the business.
If the earnings are declining over time or jump around unpredictably, then you
may want to bag your analysis and pick another stock. While there may be
money to be made trading some of these issues in the short run, the
fundamentalist is looking for steady, long-term earnings growth -- even better
if it seems to accelerate over time. You might even want to plot the
percentage growth on your spreadsheet to get an idea of just how fast the firm
is growing.
For BUD, the earnings history seems a little erratic in recent years, especially
for a producer of consumer staples like beer. The company even had a bit of
a stumble in 1995, so I went back an additional six years to get a longer view.
While the earnings picture that emerged seemed pretty stable, sloping higher
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at around 11% per year, the pace of growth also appears to be tapering off a
bit. I'll call the whole thing a yellow flag for now.
Profit Margin
The profit margin is simply the net income divided by the gross revenues (or
sales). The resulting figure (see blue line in graph below) shows the
percentage of each dollar received that made it to the bottom line as profit for
the firm.
In 1997, BUD kept 10.6 cents of every dollar
it received as profit. (Because of an excise
tax in the income statement, I used net sales
in this case. You can also do the calculation
excluding one-time charges from net income.
That's the green line in the graph.) In and of
itself, this profit margin number is pretty
much meaningless. Compared to its rival Coors (ACCOB:Nasdaq - news),
which sports a scant 3.8% profit margin, however, this profit margin starts to
look pretty good.
You can also compare Anheuser's profit margin with the entire brewing
industry on services like RapidResearch , which shows BUD sporting margins
40% higher than the industry average.
Even more telling is how margins change over a period of, say, five to six
years. Plugging a quick formula into your spreadsheet (net income divided by
gross revenues), you see that that BUD has steadily grown its profit margin
from around 8.5% in the early '90s.
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This means that Anheuser-Busch is making more money on every mug of
suds sold to the parched public. Coupled with sales increases ringing in at
nearly $13 billion for the year, those pennies really add up. What we don't
want to see is a firm with steadily declining margins.
There are two ways a company can grow earnings over time. It can either
increase revenues or cut costs. BUD seems to be handling itself well on both
fronts and gets high marks for overall profitability.
Interest Coverage Ratio
Few things will panic investors more than a company that's unable to make its
interest payments. While (most) stockholders are in for the long run and can
weather the occasional bad quarter, bond investors demand their payoff every
year like clockwork and are notoriously unforgiving if those checks stop rolling
in. The next examination of the income statement is to make sure the firm can
meet the demands of its creditors even during a temporary downturn.
The interest coverage ratio takes the earnings before interest and taxes, or
EBIT and divides it by the interest expense to figure out how many times over
the interest payments could be met with current income. Since EBIT isn't
always itemized on the income statement, you need to do some simple
figuring.
Think of the process like trying to find out the maximum number of home
mortgage payments you could make with your current level of income. The
first step is to find your taxable income for the period, which in a corporation's
case is titled intuitively enough "pretax income." You might be tempted to just
divide this number by your current debt payment to get your "mortgage
coverage ratio." But wait!
Since the government allows you to deduct this expense from your taxable
income, the pretax income figure already has your current interest payments
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taken out. Since the question is "how many houses can I afford in total" and
not "how many more houses can I afford," you need to add back the current
interest expense to your pretax income before doing the final calculation.
For BUD in 1997, the formula looks like this (figures in millions):
$1,832.5 (pretax income) + 261.2 (interest expense)
261.2 (interest expense)
=8.0
In other words, BUD has eight times as much income as it needs to make its
required interest payments. Analysts recommend that firms be able to cover
their interest charges at least three to four times over, so BUD is in great
shape here.
P/E Ratio
Akin to the earnings per share is the price-to-earnings ratio, or P/E. It's
calculated simply by dividing the market price of the stock by its current EPS
to give an earnings "multiple." The figure is a way of comparing prices of
stocks on a relative basis. A $100 stock trading at a P/E of 8 is "cheaper" than
a $20 stock with a 30 P/E.
Some folks think that low-P/E stocks are always better then high-P/E issues.
Unfortunately, there are no absolutes. High-growth stocks usually deserve a
higher multiple than their stodgier brethren because of higher expectations for
future performance. Conversely, some value investors would argue that these
high-P/E stocks have further to fall if their earnings ultimately disappoint,
because those same inflated expectations are fully priced into the stock.
Low P/E stocks seem to offer a type of safety net since the market isn't
expecting much from them in the first place. The risk here is that these
bottom-feeders might hang around their current trading levels for years and
never make a substantial move to the upside.
Our calculation of P/E relies on "trailing" earnings -- the real earnings in the
past rather than future expectations. Some analysts like to make an earnings
forecast and then quote the stock on a "forward P/E" basis. A stock, for
example, with a current multiple of 50 that is expected to double its EPS next
year would trade at a forward P/E of only 25. Admittedly, forward P/Es might
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be a better way to view the whole value proposition, but problems arise in
determining whose forecast is reliable enough to use.
That said, using current or trailing P/E to measure relative value is fine. Just
keep it in perspective. A stock trading way above its historical multiple or well
above the industry P/E and broader S&P multiple had better be up there for a
good reason (something like a hot new product, dramatically improved
productivity or promising new alliance). Conversely, a stock with a low P/E
might not be a screaming bargain if the company is having internal problems.
But assuming the stock clears the other fundamental hurdles as described
here, a relatively low-P/E stock compared to its own history or industry
average might just be the perfect value you've been waiting for. At the end of
'97 BUD was trading at 18.6 times earnings, which was about average for the
industry.
Summary
A basic approach to dissecting the income statement might go something like
this:

EPS Growth: Earnings that are steadily increasing over time at a
respectable rate get passing grades; otherwise, think hard about the



long-term prospects of such a firm.
Profit Margin: Steadily increasing profit margins get the thumbs up;
declining margins are the sign of a struggling company.
Interest Coverage Ratio: A figure of 3 to 4 is the bare minimum. Anything
higher and you're in good shape.
P/E Ratio: No absolutes here. A low one relative to the industry or historical
averages is the sign of a good value, assuming other areas check out.
Next in Part 4, we'll put it all together and flesh out the process to answer the central
question: Is BUD a buy?Part 4: Is BUD a Buy?
By Andrew Greta
Special to TheStreet.com
12/28/98 1:56 PM ET
Editor's Note: This is the fourth installment in a five-part series on the Basics
of Fundamental Analysis by Contributing Editor Andrew Greta. The first part
introduced fundamental analysis. The second part discussed dissecting the
balance sheet, using Anheuser-Busch (BUD:NYSE - news) as an example.
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The third installment reviewed BUD's income statement. Today, Greta
decides, based on the prior two days of analysis, whether BUD is a buy. He
welcomes your questions and comments , which he'll be pulling together into
a Q&A for the final installment.
We've been through the mechanics of fundamental analysis. We've shown
you the nuts and bolts, given you some basic tools and presented a blueprint
for analyzing stocks. Up until this point, our discussion has been largely based
on the known quantities of past performance. Now it's time to put it all
together, think about what our discoveries mean for the firm going forward
and decide whether to bite the bullet and buy.
A Word on Stock Values
When you invest in a company, you're not really buying the actual assets or
even the current year income. You're buying the productive power of those
assets, managed wisely, to produce earnings far into the future. This future
stream of predicted earnings is what really gives a stock its value, which is
why you hear so much about analysts' earnings estimates and "whisper"
numbers -- the unofficial estimates that industry and Wall Street insiders buzz
about.
From a textbook standpoint, the value of a stock is the entire stream of
predicted cash flows generated by the firm, discounted at a given percentage
to yield a present value of the company at today's dollars. Think of the
process like your home mortgage in reverse. Instead of hitting up your loan
officer for, say, $200,000 at 8% and asking what the payment would be,
you're offering your banker $1,467 dollars a month for 30 years and asking
what he'll pay for it now.
The big difference is that with a bank loan, the payments are extremely
predictable and the interest rate is fixed. With stock valuation, both the future
earnings and discount rate are pretty much unknown, so you get wide
variations in predicted values. In addition, small changes in today's earnings
18
have a ripple effect on future forecasts, resulting in big price swings when
companies report above or below analysts' consensus expectations.
As a result, stocks that fare well under fundamental analysis and a "value"
appraisal tend to be companies with a relatively stable earnings growth
history. That's why you see value investors focusing
predominately on blue-chips instead of tech startups. The feeling is that if you can buy a solid stream
of earnings selling at a cheap price in the market,
you'll make out like a bandit in the long run.
The Bottom Line on BUD
From our two-day analysis, it appears that BUD is a financially strong
company that's fairly valued in the marketplace. Turning to the balance sheet,
the overall financial structure of the company seems sound. It has large
physical assets, but these are financed appropriately with long-term debt and
common stock.
The current ratio (or liquidity cushion) is pretty low at 1.06, suggesting that
rapid expansion for BUD is just not in the cards. The number is stable over
time, though, so there are no major negatives -- there's just a lack of stunning
positives.
The price-to-book ratio for BUD is more than twice as high as the industry
average, indicating that management has done a good job increasing
shareholder value throughout the years. It also means that it's not much of a
bargain in the marketplace (some might even call it overvalued from this
angle), so don't look for a price-popping buyout anytime soon.
Finally, the debt-to-equity ratio is hovering right around 1.0. This is pretty
much the threshold level for strict value disciples, but more liberal analysts
would call this a decent number, and it shows a prudent balance of stock and
bond financing for the company.
Switching over to the income statement, BUD has a solid earnings picture,
albeit one that's slowing a bit over time. Again, not exactly a sprinting hare,
more like a steady-going tortoise that makes slow, constant progress year
after year.
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Profit margins, on the other hand, are high and slowly growing, confirming
BUD's dominant market position, brand loyalty and commitment to cost
reductions.
In addition, BUD has its debt obligations covered with income eight times
over. No real fear of a bankruptcy or bond default here.
Finally, the P/E is about average for the industry. Strict value players would
probably want to see that drop down below the market average before
stepping up to the plate, but it's still not what I'd call extremely extended.
So what have you got? No clear-cut, black-and-white answers to our
questions about the firm's outlook. And that's not unusual. Rarely will a stock
diagnosis show a company hitting on all eight cylinders. That's where the
good investors make the leap from science to art. They balance multiple
variables in their own minds to generate a picture of the future. If it were easy,
there'd be no advantage in the market for folks who do their homework.
In this case, what I'd do next is read up on the company and its market and
think about the firm from a less quantitative approach. BUD's main product,
beer, is simple, relatively easy to produce and seems to enjoy nearly
recession-proof sales. Major risks in terms of commodity price increases,
higher excise taxes or draconian federal legislation seem remote at best. The
tradeoff for BUD's predictability, however, is a lack of explosive growth
prospects in the domestic beer market, although international expansion is
always a possibility.
Pulling it all together, my impression is that BUD
will be a modest but relatively safe performer in
the years to come at its current price. That's not
to say it's a bad stock -- you just have to get it at
a price that undervalues its productive capability.
As such, BUD is definitely a stock to watch if the broader market drags it
down in a selloff.
If, for example, you see the P/E dip well below its historical average and you
don't think the earnings outlook has changed, that could be your buy signal.
Because of BUD's defensive nature, any price hit will probably be based more
on general market anxiety than on the fundamentals of the company, which
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should remain pretty solid going forward. Let's face it, even in the midst of
Armageddon, folks still gotta have their cold frosty. For me to think of BUD as
a major growth prospect, however, it would need to show some new
innovations in either products or markets where it expects to make big sales
gains.
This series presented a mere taste of the complex world of fundamental
analysis. Now it's time for you to pick a stock and give it all a try. I'm anxious
to hear any comments or questions, which I'll try to answer in the Q&A I've
been preparing for this series. I've already received many terrific questions.
Please keep them coming .
For Further Reading:
The selection of reference materials geared toward the educated investor out
there is pretty slim from what I've seen. Here are a few titles that have
crossed my desk over the years and may prove helpful in your own quest to
understand corporate financials. Feel free to email me your personal favorites
so we can include them in subsequent pieces.
Graham & Dodd's Security Analysis
This is one dry tome, but it's considered the fundamentalist's bible. Parts 2
and 4 -- on statement analysis and stock valuation, respectively -- seem to be
the most valuable sections for the individual investor. Numerous ratios are
printed inside the front and back covers of the latest edition for easy
reference.
How to Profit from Reading Annual Reports by Richard B. Loth
This isn't particularly well written or organized, but it's one of the few books I
could find on the subject geared toward the layman.
Financial Accounting: An Introduction to Concepts, Methods and Uses by
Clyde P. Stickney and Roman L. Weil
This one's my old college managerial accounting text. It's got an entire chapter on
financial statement analysis, including a section on useful ratios and their limitations.
I'm not sure I'd spend the $96 again for a new one, but if you've got one serving as a
doorstop, dust it off for review.Part 5: Reader Q&A
By Andrew Greta
Special to TheStreet.com
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12/24/98 11:20 AM ETFirst off, thanks for all of the well-thought-out questions
and supportive comments on our recent series on dissecting companies'
financials. Many readers, it seems, are already methodically hacking away at
the tangled jungle of fundamental analysis, searching for undiscovered jewels
in the form of solid, long-term investments.
Most also seem well aware of the inherent vagaries of their chosen labor yet
remain undaunted by the challenge. They prove that the concept of hard work
and discipline is still intact even amid the market's siren song of quick and
easy money.
Your questions highlight what a tough chunk of meat we bit off to chew and
why other publications rarely tackle the subject. There seem to be as many
ways of analyzing a company's finances as there are investors out there to
crunch the numbers. And while plenty of approaches are just plain wrong,
you'll rarely find a single right way or one that magically releases a cudgeltoting genie to beat you over the head with a definitive answer. The process is
just too big to fit neatly into a one-size-fits-all formula.
This Q&A will be an attempt to keep you out of the quicksand and on the firm
ground of proven analytical principals. It will also be a place where TSC
readers can exchange ideas on fundy analysis. If you have further questions
or ideas to contribute, send them my way, with your full name.
What Is Shareholder's Equity?
In the "Balance Sheet" piece you mention that assets are recorded at book
value (cost minus depreciation). Then you say book value is synonymous with
shareholder's equity. I thought equity was "assets minus liabilities," so they
can't be synonymous, right?
Mike Davis
Mike,
You articulate a common confusion that stems from the dual use of the term
"book value." In the first sense, it's an accounting term that does indeed refer
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to the original cost of an individual asset adjusted for any accumulated
depreciation or amortization.
In the second sense, when talking about the firm as a whole, it refers to the
excess of total assets over total liabilities (or the definition of shareholder's
equity). The idea is that when you're trying to find the value of an entire firm, it
doesn't do a lot of good to just look at what they own (assets) without
subtracting what they owe (liabilities). So in an investment sense, when
someone refers to the book value of a stock, as opposed to an individual
asset, think "shareholder's equity."
Still Confused on Shareholder's Equity
So is shareholder's equity just the number of shares of stock outstanding
times the current share price?
Karen Baxter
Karen,
The answer is no. Shares outstanding times market price is what's commonly
referred to as "market capitalization" (or just "market cap"). Market cap tells
you the market value of the entire company at a given point in time.
Shareholder's equity on the other hand, gives you the value of the firm in
terms of "book value" (a confusing term that is described in Mike's question;
here we mean the second sense described above). The difference between
the market value and the book value represents how good a job management
has done in increasing shareholder value. It also can give you an idea of the
relative value of the stock at its current price (see price-to-book value
discussion in the series).
Good Question on Goodwill
Could you comment on how to view "goodwill" on the balance sheet when
grading the quality of a company?
P. Souther
P.,
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In this case, "goodwill" isn't the place where sitting presidents drop off their
used underwear to claim a $4-per-pair tax deduction. It's the excess amount
above "fair market value" that a firm paid for another company during an
acquisition. It falls under the rubric of "intangible assets." Other intangibles
can include things like patents and trademarks -- but only if they're purchased
from another party. Internally generated intangibles aren't generally recorded
on the books at all (don't ask me why, I just work here). So you may find
goodwill on the books in the wake of an acquisition.
Informally, you can think about goodwill as the value of things like positive
customer relations, brand loyalty or anything else that could result in greaterthan-normal earnings power. For example, you can bet that the "Golden
Arches" would garner a hefty goodwill kicker if Micky Dee's ever got
swallowed up by Mr. Softee.
So how does it affect your analysis? A relatively large amount of goodwill
could indicate that a firm overpaid for its acquisitions in a fit of market
euphoria. In addition, carrying a lot of goodwill on the balance sheet might
spawn a deceptively low price-to-book ratio, leading you to think you've got a
cheap stock on your hands. Some conservative analysts correct for the
aberration by reducing a firm's shareholder's equity by the amount of
intangible assets to get something called "tangible net worth." Not a big deal if
goodwill is low, but something to consider with a firm suffering a hangover
from an acquisition binge.
Interest Coverage Ratio Challenge
In your interest coverage ratio calculation, I question whether it is appropriate
to add back interest expense without adjusting for interest income and other
nonoperating sources of income.
Chris Karlin, CFA
Chris,
A better example of a stylistic difference in fundamental analysis you'll rarely
find (you say "day-tah," I say "daa-tah").
I was taught that the "earnings before interest and taxes" (EBIT) figure in your
interest coverage ratio should include all sources of income and other
24
expenses, regardless of where they come from. This makes sense to me
since I want to find out how well a firm can cover its debt payments as a
whole, not just from operating income. However, I'm open to other
interpretations.
Simply using "operating income" as your EBIT figure as you seem to suggest
not only makes for an easier calculation, but it also gives you a more
conservative coverage ratio. However, unless these "other" income and
expense categories are large (which they aren't in the case of AnheuserBusch (BUD:NYSE - news)), the end result should be nearly identical.
To carry the idea even further, some analysts argue that using EBIT in the
first place is a bad idea. Since firms service debt out of current funds (e.g.,
cash), they suggest that using net cash flow in the numerator is a better
method. I'm receptive to that idea too, especially if the company's standard
interest coverage ratio is two or less.
Any Nuts and Bolts to Biotech?
My question is about biotech/pharmaceutical start-ups. I was wondering if
there are any pointers to look at when investing in these sectors where
companies are not making a profit at all and often don't until several years or
more after they discover a marketable product.
Michael Hailley
First off, don't confuse an investment with a crapshoot. Unless you know
something definitive about a new product under development, any kind of
start-up betting on a yet-to-be-invented wonder drug is usually little more than
a roll of the dice. Not that you shouldn't feel free to take a flier every once in a
while, just don't bet your life savings.
That said, one of the few things that a fundamental read on these firms can do
for you is determine if they can survive long enough to discover their pot of
gold. I'd plot their "burn rate" (sort of a negative EPS trend) to see how fast
they're using up capital. Then try to assess how long they can last without an
injection of fresh funds.
Other principals of the fundy view still apply. Are they financed appropriately
with mostly equity and only enough debt to cover hard assets like medical
25
equipment? Do they have enough cash flow to make their interest payments?
Just running the financials through a few fundamental checks might convince
you that many of these paper tigers aren't worth the risk of losing everything
for the remote chance at a phenomenal windfall.
Book Selections
These titles come to us straight from the TSC readership and staff. I haven't
personally checked any of them out, so I'll let their comments speak for
themselves.
Savvy Investing for Women by Marlene Jupiter
One of the easiest books to read and understand and has some great
chapters on balance sheets and income statements. I know, you'll say men
won't read it. That's a shame because it clearly explains many aspects of
investing for everyone -- not just women.
Submitted by Terry Kish, State College, Pa.
Security Analysis on Wall Street by Jeffrey C. Hooke
Targeted at serious investors, investment professionals, corporate managers
and MBA students, the book isn't as simple to read as a "Ten Stocks to
Watch" article you might find in a glossy investment magazine. But it doesn't
require an expertise in calculus, either.
Submitted by George Mannes, TheStreet.com
How to Read a Financial Report: Wringing Vital Signs Out of the Numbers by
John A. Tracy, PhD, CPA
The fourth edition was published in 1994 and is written in a style similar to
yours -- clear and concise. He demonstrates to the reader how to read the
three financial statements and how they are interrelated.
Submitted by Francis Navarro
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