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Introduction to Fundamental Analysis
Fundamental analysis involves the in-depth study of a
company in order to determine values and future trends. While the main focus
is on a company’s financials, it’s also critical to analyze the economic
environment and the industry in which a company operates. The focus of this
section is to find values, by using “bottom up” financial analysis; economic
and industry analysis will be left for another day. The goal is to help
bring financial concepts “alive.”
Knowing the numbers is critical in spotting values.
Start by reviewing a company’s business model, which
is the company’s method for generating revenues, costs, and profits.
This is not as abstract as it may seem. I once met
with a high-level executive who described that her company was having a
great year. They were able to raise more money from investors then the
company spent. When I asked about revenues, she mentioned that their
revenues were how much they raised from investors, not from actual sales. As
a CPA, my outlook was completely different. While they viewed themselves as
having a good year because they raised capital, I viewed them as a start-up,
without a proven business model. At the time, they were not transitioned and
were not positioned, to generate sales or profits. While they were promoting
their technological prowess, their true skill was at raising money. This
example demonstrates, moreover, that a company’s business model needs to
coincide with investors’ goals and objectives.
Investors
first need to thoroughly understand a company’s revenue stream, by finding
out what actual products or services the company offers. Dig deeper than
vague general categories; identify the specific products made and how are
they used. Determine their selling prices and try to estimate their profit
margins. Ascertain who the company’s customers are. In many cases, the
ultimate purchaser of a company’s products may not be the company’s
customer. Companies may sell to distributors, wholesalers and retailers, but
not to the final customer. Investors also need to determine where the
customers are located, and how the products or services are delivered to
them. Know exactly where the cash is coming from to pay the bills.
Don’t ignore the cost side of the profit equation
(revenues minus expenses equal profits). Go beyond the costs to sales ratio
trends. Investors need to consider facts such as: how large is the
workforce, and where are they located? Does the company design and
manufacture its products? Do they outsource manufacturing or service
departments and if so, where are they located and what are the risks? What
are they purchasing and who are the suppliers? Are just-in-time inventory
practices utilized?
If the company is a service organization, how is it
structured, where are its offices, how many employees does it have, and how
much does it pay its billable employees? Are there “costs plus” billing
arrangements?
One must also get a handle on research and
development expenses. Go beyond the typical “R&D as a percentage of sales”
calculation. What exactly are the scientists and engineers researching, what
types of returns are expected, and what are the time frames of the potential
payoffs?
Understand the company’s organization and reporting
structure. What are its main divisions, subsidiaries, and profit centers;
every company slices the pie differently. Does it have a centralized or
decentralized organization? Is it structured correctly to make acquisitions,
or could it be the acquired?
The goal is to understand how a company operates; and
what are its special qualities that make it a sound investment.
Most of this information is contained in the
company’s SEC form 10K, which is filed annually, normally within 75 days
after the company’s year-end. The quarterly 10Q statements are normally not
as comprehensive as the annual report and are more of an update to the
annual report. They are due 45 days after the quarter-end, except the last
quarter, which is incorporated into the annual filing.
While fundamental analysis is time consuming, I
rather think of it as potential wealth building.
After understanding the company’s business model, one
must then determine if the company’s strategy is profitable and is it a good
investment choice for you. Is the stock valued at a price on which you can
make a good return? After all the analysis, it still comes down to price
versus expected return.
Click below for more information on "the numbers":
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