Friday, April 23, 2010

Fundamental Analysis (Part 1)

A Guest Post by Ange Lim

First Things First

Before anything else, I’d like to begin by setting the parameters of this entry. My goal is not to fully educate readers on the concept of Fundamental Analysis. Rather, I hope to shed some light on the topic to show the usefulness of such a tool. I must warn you though: you can only get the most out of this if you have some background on the different financial statements, their functions, and their relevance. Fortunately, Investor Juan has already touched on those topics in his earlier posts about the balance sheet, the income statement, and the statement of cash flows.

Brief Background

Now let’s get down to business. Ever heard of Benjamin Graham, Warren Buffett, Walter Schloss, Peter Lynch, or John Templeton? I’m sure you know at least one of them—Buffett, the third richest man in the world. But Buffett did not become rich on his own. He took a class on security analysis, which provided him with sufficient knowledge to make it big investing in the right stocks. He credits his success to his teacher and mentor, Ben Graham, the “Father of Fundamental Analysis”. Graham more or less set the ground rules in investing profitably in the stock market, while the other three names mentioned above benefited so much from this that they eventually became recognized as some of the great equity investors of the century (Schloss was actually also Graham’s student).

But What is It Really?

Having given credit where credit is due, we can now define what “fundamental analysis” is in the context of the stock market. Simply put, it is a process of analyzing the fundamental factors that affect the profitability and value of a company: its financial status as shown in its financial statements, the economic conditions surrounding it, and the industry of which it is a part. The goal is to determine a company’s value relative to its current and future market price; by “value”, we are referring to its intrinsic value, which is what the company is really worth based on the future cash flows that it is expected to generate in the future. The result of this analysis is to determine whether or not it is profitable for the investor to buy or sell the company's stock.

Value investors use fundamental analysis to “pick” the stocks they can extract the most profit from. The trick here is to find a stock currently selling at a discount (when the intrinsic value is greater than the stock price) and buy it to earn what is called a “margin of safety.” When the stock price rises, then the investor can earn significant profit by selling the stock (note that I said “when” and not “if”; fundamental analysis assumes that a stock selling at a discount will eventually appreciate and catch up with its intrinsic value). That’s a contrarian strategy right there: to buy when the price is low and to sell when it is high. Sounds simple? This is just the start of it. It can get tedious, especially when it comes to computing for the intrinsic value of the stock; but all that tedium just ensures that the investor makes only rational and fundamentally sound investment decisions.

Because a List is a Great Way to See the Bigger Picture

Feel like you’re ready to take this on? It’s game time. Below are 5 simple steps to get you started on fundamental analysis.

1. Check the economy

Before you even think about investing in the stock market, you have to know if the present is such a good time to do so or if you’ll be better off investing elsewhere. The stock market doesn’t promise winners. In physics, it is said that for every action, there’s always an equal and opposite reaction. The same is true with stock investing: when someone wins, another person loses. So be careful about timing your investment: check macroeconomic vital signs like interest rates, inflation rates, and of course, the status of international markets. Only when you’re comfortable with the situation should you move forward.

2. Start with what you know

If you’re new to the stock market, you might get overwhelmed by the number of publicly listed companies. You might be initially interested in investing in more familiar stocks like this local telecommunications juggernaut or this rapidly expanding conglomerate controlled by one of the country’s top business magnates. But the best way to go about it is to start with a company or industry you’re genuinely interested in and the one you are most familiar with.

3. Narrow down your search

So you already have an industry in mind; the next step is to narrow down your search. Study your industry: its uniqueness and peculiarities, the major players, and the typical business cycle, among other things. Check out which companies perform better than others in terms of revenues, expenses, and net income. Pick one company you want to focus on and another to use as benchmark so that you will have a clear picture of how your choice company compares with others in the industry. Checking the income statement is probably the easiest thing to do for someone with limited exposure to financial statements, so we can go with this as a preliminary test—just to shortlist the candidates. Don’t worry, the information needed is pretty easy to obtain since publicly listed companies are required to regularly release financial statements. They post their annual reports either on their respective websites or on the Philippine Stock Exchange site.

4. Befriend annual reports

Now that you have your choice company, let’s level up a bit further. The financial statements of the company will be your close circle of friends. Normally, analysts use five years’ worth of financial statements so that trends can more easily be identified; this takes more time, yes, but at least you will be able to come up with a more sound analysis. Then compute for key financial ratios like the Profit Margin, Return on Equity, Return on Assets, Accounts Receivable Turnover Ratio, Inventory Turnover Ratio, Current Ratio, and the Price-to-Earnings Ratio. Some investors, though, are more interested in the company’s earnings growth rate so some ratios might not be applicable to them.

Apart from important financial data, the annual report also holds valuable qualitative information that is critical in fundamental analysis; most of these can be found in the Management Discussion and Analysis (MD&A) portion of the report. Here, management gives an explanation of the year’s performance and notifies readers of future expectations. You can also get other qualitative information from actual interviews with management and the board (a little food for thought: sometimes, prices positively move despite poor quantitative outlook because of certain people backing the stock), but that might be difficult to do if you’re not affiliated with the right people or institutions.

The proxy statement, required also by the Securities and Exchange Commission (SEC), is another source of qualitative information you might want to check out. It covers the compensation packages and benefits that managers, board members, and executives receive and how this is tied to the company’s actual earnings. If their salaries or benefits are based on the company’s performance, then rest assured that you won’t get surprised halfway through your analysis by self-serving moves made by management.

A third thing you should also consider when comparing companies’ performances in the same industry is brand equity. Just how well-known and big is this company to be able to face economic and business problems that should arise in the future?

5. Get your hands dirty with valuation

After making all the preliminary analyses and computing for the necessary ratios and figures, we are now ready to put everything together. We don’t take these ratios separately; they will make more sense when analyzed together. But the way the company’s stock will be valued will depend on the method you are most comfortable with and what is most applicable to the company you are analyzing.

Click here for Part 2.
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