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Fundamental Analysis

Fundamental analysis is a technique that helps determine the value of a stock by focusing on the underlying factors that affect a company’s performance and growth prospects. It can also be carried out on an industrial sector or entire economy. Fundamental analysis gives an insight on a company’s revenues and ability to make profit, as well a company’s ability to repay its debts and its position in the markets relative to its competitors.

 

Fundamental analysis can be broken down into quantitative and qualitative factors. Quantitative fundamentals can be calculated and expressed in numerical terms to help investors make decisions on stocks.

 

Qualitative fundamentals are less tangible factors that affect a business such as brand name recognition, patents and competence of a company’s executives and board members. A company’s financial statements are the most 

reliable source of quantitative data and one can determine revenue, profit, assets, liabilities and performance related ratios more precisely.


Fundamental analysis is based on the assumption that markets do not always price stocks correctly and that a stock’s price on the stock market does not fully reflect its real value. The real value of a stock is known as intrinsic value, and fundamental analysis assumes that in the long run the markets will catch up with fundamentals and reflect this value on stocks. Investors look to invest in stocks that are trading below their intrinsic value.

 

Qualitative factors considered in fundamental analysis include:

 

  • A company’s business model
  • Competitive advantage, operational effectiveness and strategic positioning
  • Management, education background, employment history and achievements of company executives.
  • Corporate governance of a company including financial and information transparency, shareholder rights
  • Structure of board of directors
  • Customer base of company
  • Market share
  • Industry growth
  • Competition
  • Regulation

 

Fundamental Analysis: The Income Statement

 

The income statement shows figures such as revenue, earnings and earnings per share. It shows how much money the company generated (revenue), how much it spent (expenses) and the difference between the two (profit) over a certain period of time.

 

The income statement gives investors insight on how well the company’s business is performing i.e. whether the company is making profit or incurring loses. Companies with low expenses relative to revenue - or high profits relative to revenue attract investments as they signal strong fundamentals to investors. Consistent sales growth increases company revenues and is a strong driver of profitability and growth. Valuable revenues are those that continue year in year out, short term increases are less valuable and are likely to get a lower price to earnings multiple for a company.

 

The two most common expenses are the cost of goods sold (COGS) and selling, general and administrative expenses (SG&A). Cost of goods sold is the expense most directly involved in creating revenue. It represents the costs of producing or purchasing the goods or services sold by the company. Costs involved in operating the business are SG&A. This category includes marketing, salaries, utility bills, technology expenses and other general costs associated with running a business. SG&A also includes depreciation and amortisation.

 

Companies must include the cost of replacing worn out assets in expenses. Some corporate expenses, such as research and development (R&D) at technology companies, are crucial to future growth and should not be cut, even though doing so may reduce expenses and increase earnings on the income statement. Financial costs, notably taxes and interest payments also need to be carefully looked at.

 

Profits = Revenue - Expenses

 

There are several commonly used profit sub-categories that tell investors how a company is performing. Gross profit is calculated as revenue minus cost of sales.

 

Companies with high gross margins will have a lot of money left over to spend on other business operations, such as research and development or marketing which may enhance future growth prospects. A downward trend in the gross margin rate over time can be a sign of future problems facing a company. Year on increases on cost of goods sold are likely to lower gross profit margins and a company with such a trend may have to pass these costs onto customers in the form of higher prices to maintain profitability. This may have an adverse effect on a company’s competitive position in comparison to its competitors and have an impact on its future prospects.

 

Operating profit represents the profit a company makes from its actual operations, and excludes certain expenses and revenues that may not be related to its central operations. High operating margins can mean the company has effective control of costs, or that sales are increasing faster than operating costs. Operating profit also gives investors an opportunity to do profit-margin comparisons between companies that do not issue a separate disclosure of their cost of goods sold figures (which are needed to do gross margin analysis). Operating profit is a more reliable measure of profitability as it is harder to manipulate than net earnings.

 

Net income represents a company's profit after all expenses, including financial expenses, have been paid. A high profit margin usually means that a company has one or more advantages over its competitors. Companies with high net profit margins have a bigger cushion to protect themselves during a financial crisis or in periods of economic downturns. Companies with low profit margins can find it difficult to survive in a downturn. Companies with profit margins reflecting a competitive advantage are also likely to capitalise by increasing their market share during the hard times - leaving them even better positioned for the future.

 

The income statement can give a valuable insight to investors about a company. Increasing sales offers the first sign of strong fundamentals. Rising margins indicate increasing efficiency and profitability. It is useful to determine whether a company is performing in line with industry peers and competitors. It is also important to look out for indicators such as changes in revenues, costs of goods sold and SG&A to get a sense of the company’s profit fundamentals.

 

Fundamental Analysis: The Balance Sheet

 

The balance sheet highlights the financial condition of a company and is an integral part of the financial statements. It offers a snapshot of a company's health by showing how much a company owns (its assets), and how much it owes (its liabilities). The difference between what it owns and what it owes is its equity, also known as net assets or shareholders equity.

 

A lot about a company's fundamentals i.e. how much debt the company has, how much it needs to collect from customers (and how fast it does so), how much cash and equivalents it possesses and what kinds of funds the company has generated over time can be obtained from the balance sheet.

 

Assets:

 

There are two main types of assets: current assets and non-current assets. Current assets are likely to be used up or converted into cash within one business cycle - usually around twelve months. The three important current asset items found on the balance sheet are: cash, inventories and accounts receivables.

 

Investors can be attracted to companies with plenty of cash on their balance sheets as it offers some sort of security during economic downturns and it offers companies more options for future growth. Growing cash reserves often signal strong company performance whilst a dwindling cash reserve could be a sign of trouble. However if a lot of cash is a permanent feature of the company's balance sheet, investors may ask questions on why the money is not being put to use. Cash can be a sign of a lack of investment opportunities or a suggestion that the management of a company is too short-sighted to come up with viable investment proposals.

 

Inventories are finished products that have not yet been sold. Investors want to know if a company has too much money tied up in its inventory. Inventory turnover (cost of goods sold divided by average inventory) measures how quickly the company is moving stock through the warehouse to customers. If inventory grows faster than sales, it is almost always a sign of deteriorating fundamentals.

 

Receivables are outstanding debts (what is owed to the company). The speed at which a company collects what it is owed can be an indicator of its financial efficiency. A growing collection period is usually not a good sign to investors. The company may be letting customers stretch their credit in order to recognise greater top-line sales and that can be an indicator of future problems, especially if customers fail to meet their payment obligations. If a company gets its customers to make payments quicker, it can utilise the cash to pay for salaries, equipment, loans, and dividends and capitalise on growth opportunities.

 

Non-current assets include fixed assets, such as property, plant and equipment (PP&E). Investors pay less attention to fixed assets since companies are often unable to sell their fixed assets within any reasonable amount of time. They are carried on the balance sheet at cost regardless of their actual value. As a result, it's is possible for companies to grossly inflate this number, leaving investors with questionable and hard-to-compare asset figures.

 

Liabilities:

 

Current liabilities are obligations the firm must pay within a year, such as payments owing to suppliers. Non-current liabilities represent, what the company owes but is due in a year or more time. Typically, non-current liabilities represent bank and bondholder debt.

 

Falling debt levels are a good sign. If a company has more assets than liabilities, then it is in decent condition. By contrast, a company with a large amount of liabilities relative to assets needs to be examined with more diligence. If a company has too much debt relative to cash flows required to pay for interest and debt repayments, then it can easily go bankrupt.

 

In order to determine a company’s ability to meet its short term debt obligations, the quick ratio can be used. This is obtained by subtracting inventory from current assets and then dividing by current liabilities. If the ratio is 1 or higher, the company has enough cash and liquid assets to cover its short-term debt obligations.


 

Quick Ratio =Current Assets - Inventories

Current Liabilities

 

 

Equity:

 

Equity represents what shareholders own, so it is often called shareholder's equity. Equity is equal to total assets minus total liabilities.

 

Equity = Total Assets – Total Liabilities

 

The two important equity items are paid-in capital and retained earnings. Paid-in capital is the amount of money shareholders paid for their shares when the Initial Public Offering (IPO) was made. Retained earnings are a tally of the money the company has chosen to re-invest in the business rather than pay to shareholders. Investors and analyst look closely at how a company puts retained capital to use and how a company generates a return on it.

 

Some assets and debt obligations are not disclosed on the balance sheet. Companies often possess hard-to-measure intangible assets. Corporate intellectual property (items such as patents, trademarks, copyrights and business models), goodwill and brand recognition are all common assets in today's marketplace. they are not listed on company's balance sheets but are worth considering when carrying out fundamental analysis.

 

It is important to look out for off-balance sheet debt and other off-balance sheet risks. This can be in the form of financing in which large capital expenditures are kept off of a company's balance sheet through various classification methods. Companies will often use off-balance-sheet financing to keep the debt levels low.

 

Fundamental Analysis: The Cash Flow Statement

 

The cash flow statement shows how much cash comes in and goes out of the company over a given period of time usually quarterly or yearly. It is distinguished from the income statement because of accrual accounting, which is found on the income statement. Accrual accounting requires companies to record revenues and expenses when transactions occur, not when cash is exchanged. The income statement often includes non-cash revenues or expenses, which the statement of cash flows does not include.

 

The cash flow statement is crucial in understanding a company’s fundamentals as it shows how much actual cash a company has generated. It shows how the company is able to pay for its operations and finance future growth. A profit on the income statement does not mean that a company cannot get into trouble later because of insufficient cash flows. A close examination of the cash flow statement can give investors a better sense of how the company will fare.

 

Companies produce and consume cash in different ways, so the cash flow statement is divided into three sections: cash flows from operations, financing and investing. The sections on operations and financing show how the company gets its cash, while the investing section shows how the company spends its cash.

 

Investors are attracted to companies that produce plenty of free cash flow (FCF). Free cash flow signals a company's ability to pay debt, pay dividends, buy back stock and facilitate the growth of business. Free cash flow, which is essentially the excess cash produced by the company, can be returned to shareholders or invested in new growth opportunities without hurting the existing operations.

 

Ideally, investors would like to see that the company can pay for the investing figure out of operations without having to rely on outside financing to do so. A company's ability to pay for its own operations and growth signals to investors that it has very strong fundamentals.

 

Fundamental Analysis: Other Important Sections Found in Financial Filings

 

The financial statements are not the only parts found in a business's annual and quarterly reports. There are other sections which may contain valuable information for investors and analysts which include:

 

Management Discussion and Analysis (MD&A):

 

This provides investors with a clearer picture of what the company does, and also points out some key areas in which the company has performed well. If a company gives a decent amount of information in the MD&A, it's likely that management is being upfront and honest. If the MD&A ignores serious problems that the company has been facing, then investors have to be cautious with the firm.

 

The Auditor's Report:

 

It is a legal requirement for every public company that trades stocks or bonds on an exchange to have its annual reports audited by a certified public accountants firm. An auditor's report is meant to scrutinise the company and identify anything that might undermine the integrity of the financial statements.

 

Audits give credibility to the figures reported by management. While quarterly statements are not audited, one should be very wary of any annual financials that have not been audited by an approved accountant.

 

The Notes to the Financial Statements:

 

The notes to the financial statements (sometimes called footnotes) tie up any loose ends and complete the overall picture. The footnotes list important information that could not be included in the actual ledgers. For example, they list relevant things like outstanding leases, the maturity dates of outstanding debt and details on compensation plans, such as stock options, etc.

 

There are two types of footnotes:

 

Accounting Methods - This type of footnote identifies and explains the major accounting policies of the business that the company feels that you should be aware of. This is especially important if a company has changed accounting policies. It may be that a firm is changing policies only to take advantage of current conditions in order to hide poor performance.

 

Disclosure - The second type of footnote provides additional disclosure that simply could not be put in the financial statements. The financial statements in an annual report are supposed to be clean and easy to follow. To maintain this cleanliness, other calculations are left for the footnotes. For example, details of long-term debt - such as maturity dates and the interest rates at which debt was issued - can give you a better idea of how borrowing costs are laid out. Other areas of disclosure include everything from pension plan liabilities for existing employees to details about ominous legal proceedings involving the company.

 

Fundamental Analysis: Valuation Methods

 

Discounted Cash Flow:

 

The premise of the discounted cash flow method is that the current value of a company is simply the present value of its future cash flows that are attributable to shareholders.

 

A company’s present value of future cash flows is compared to the current value of the company to determine whether the company is a good investment, based on it being undervalued or overvalued.

 

There are several different techniques within the discounted cash flow method of valuation, essentially differing on what type of cash flow is used in the analysis. The dividend discount model focuses on the dividends the company pays to shareholders, while the cash flow model looks at the cash that can be paid to shareholders after all expenses, re-investments and debt repayments have been made. But conceptually they are the same, as it is the present value of these streams that are taken into consideration.

 

A considerable amount of estimates and assumptions that go into the model and forecasting the revenue and expenses for a firm five or 10 years into the future can be considerably difficult. Nevertheless, DCF is a valuable tool used by both analysts and investors to estimate a company's value.

 

Ratio Valuation

 

Financial ratios are mathematical calculations using figures mainly from the financial statements, and they are used to gain an idea of a company's valuation and financial performance. Some of the most well-known valuation ratios are price-to-earnings and price-to-book. Each valuation ratio uses different measures in its calculations.

 

The calculations produced by the valuation ratios are used to gain some understanding of the company's value. The ratios are compared on an absolute basis, in which there are threshold values. Valuation ratios are also compared to the historical values of the ratio for the company, along with comparisons to competitors and the overall market itself.

 

Earnings:

 

Most investors want to know about the earnings of a company. How much money the company is making and how much it is going to make in the future are the key areas of interest. Earnings are profits and influence investors’ decisions on company stocks. Increasing earnings generally lead to a higher stock price and, in some cases, a regular dividend.

 

When earnings fall short, the market may respond adversely to the stock. Every quarter and annually, companies report earnings. Analysts follow major companies closely looking at their quarterly and annual reports and if they fall short of projected earnings, sound the alarm.

 

The Earnings Per Share ratio:

 

Earnings Per Share = Net Earnings / Outstanding Shares

 

There are three types of EPS numbers:

 

Trailing EPS – last year’s numbers and the only actual EPS

Current EPS – this year’s numbers, which are still projections

Forward EPS – future numbers, which are projections

 

Price to Earnings Ratio:

 

The P/E looks at the relationship between the stock price and the company’s earnings. It is calculated by taking the share price and dividing it by the company’s EPS.

 

P/E = Stock Price / EPS

 

The P/E gives you an idea of what the market is willing to pay for the company’s earnings. The higher the P/E the more the market is willing to pay for the company’s earnings. Some investors read a high P/E as an overpriced stock and that may be the case, however it can also indicate the market has high hopes for this stock’s future and has bid up the price.

 

A low P/E may indicate a vote of no confidence by the market or it could mean this is a sleeper that the market has overlooked. It may be a value stock, which is something many investors make wealth spotting before the rest of the market discovered its true worth.

 

Projected Earnings Growth (PEG):

 

The P/E compares the relative value of stocks based on earnings by taking the current price of the stock and dividing it by the Earnings Per Share (EPS). This reflects whether a stock’s price is high or low relative to its earnings.

 

Some investors may consider a company with a high P/E overpriced and they may be correct. A high P/E may be a signal that traders have pushed a stock’s price beyond the point where any reasonable near term growth is probable. However, a high P/E may also be a strong vote of confidence that the company still has strong growth prospects in the future, which should mean an even higher stock price.

 

The market is usually more concerned about the future than the present; therefore it is always looking for some way to project out. Another ratio used to look at future earnings growth is called the PEG ratio. The PEG factors in projected earnings growth rates to the P/E. PEG can be calculated by taking the P/E and dividing it by the projected growth in earnings.

 

PEG = P/E / (projected growth in earnings)

 

The lower the number the less you pay for each unit of future earnings growth. A stock with a high P/E, but high projected earning growth may still be a good value. However looking at a low P/E stock with low or no projected earnings growth, what looks like a value may not turn out to be good value. For example, a stock with a P/E of 8 and flat earnings growth equals a PEG of 8. This could prove to be an expensive investment.

 

It is important to note that PEG is about year-to-year earnings growth and relies on projections, which may not always be accurate.

 

Price to Sales Ratio:

 

This metric looks at the current stock price relative to the total sales per share. The P/S is calculated by dividing the market cap of the stock by the total revenues of the company. The P/S can also be calculated by dividing the current stock price by the sales per share.

 

P/S = Market Cap / Revenues

 

or

 

P/S = Stock Price / Sales Price Per Share

 

The P/S number reflects the value placed on sales by the market. A lower P/S may represent better value of a stock. It is advisable not to use this ratio in isolation.

 

The Price to Book ratio or P/B:

 

This measurement looks at the value the market places on the book value of the company. The P/B is calculated by taking the current price per share and dividing by the book value per share.

 

P/B = Share Price / Book Value Per Share

 

Like the P/E, the lower the P/B, the better the value. Value investors will use a low P/B is stock screens, for instance, to identify potential candidates.

 

Dividend Payout Ratio:

 

The Dividend Payout Ratio measures what a company pays out to investors in the form of dividends. This is calculated by dividing the annual dividends per share by the Earnings Per Share.

 

DPR = Dividends Per Share / EPS

 

Growing companies will typically retain more profits to fund growth and pay lower or no dividends. Companies that pay higher dividends may be in mature industries where there is little room for growth and paying higher dividends is the best use of profits. The DPR must be viewed in the context of the company and its industry as it tells very little when used in isolation.

 

Dividend Yield:

 

This measurement tells what percentage return a company pays out to shareholders in the form of dividends. Older, well-established companies tend to payout a higher percentage than do younger companies and their dividend history can be more consistent. The Dividend Yield is calculated by taking the annual dividend per share and dividing it by the stock’s price.

 

Dividend Yield = annual dividend per share / stock's price per share

 

Book Value:

 

A company’s stock price reflects how much it is worth/ its value. There are several ways to define a company’s worth or value. One of the ways you define value is market cap or how much money would be needed to buy every single share of stock at the current price.

 

Another way to determine a company’s value is to look at the Book Value. The Book Value is simply the company’s assets minus its liabilities.

 

Book Value = Assets - Liabilities

 

A company that is a viable growing business will always be worth more than its book value for its ability to generate earnings and growth. Book value appeals more to value investors who look at the relationship to the stock's price by using the Price to Book Ratio.

 

The best way to compare companies is by converting to book value per share, which is simply the book value, divided by outstanding shares.

 

Return on Equity:

 

Return on Equity (ROE) is one measure of how efficiently a company uses its assets to produce earnings. ROE is calculated by dividing Net Income by Book Value. A healthy company may produce an ROE in the 13% to 15% range. It is advisable to compare companies in the same industry to get a better picture of how well a company is doing.

 

The ROE is a useful measure but it has some flaws that can give a false picture to investors and analyst, so it is not to be used in isolation. For example, if a company carries a large debt and raises funds through borrowing rather than issuing stock it will reduce its book value. A lower book value means you’re dividing by a smaller number so the ROE is artificially higher. There are other situations such as taking write-downs, stock buy backs, or any other accounting slight of hand that reduces book value, which will produce a higher ROE without improving profits.

 

It may also be more meaningful to look at the ROE over a period of the past five years, rather than one year to average out any abnormal numbers. ROE is a useful tool in identifying companies with a competitive advantage. All other things roughly equal, the company that can consistently make more profits with their assets, will be a better investment in the long run.

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