Investment success is pretty much a matter of careful selection and timing of stock purchases coupled with impeccable matching to your individual risk tolerance. In order to carry out selection, timing and matching actions an investor must conduct deep security analysis. The first two steps in security analysis are Economic Analysis and Industry Analysis which have been covered in the first two installments of this three part series. The third step is Fundamental Analysis which is the in-depth study of the finances and operating outcomes of a company.
We believe the value of common stock is determined in large measure by the performance of the firm that issued the stock. If the company is healthy and can demonstrate strength and growth, the value of the stock will increase. When values increase then prices follow and returns on an investment will increase. However, just to keep the savvy investor on their toes, the mix is complicated by the risk factors involved. Fundamental analysis examines all the dimensions of risk exposure and the probabilities of return, and merges them with broader economic analysis and greater industry analysis to formulate the valuation of a stock.
Look at the company from inside and outside to identify their strong points and how they are taking advantage of them. Identify weaknesses and how they guard against them and seek to overcome them. Assess the speed and effectiveness of actions to fend off threats and take advantage of opportunities. Financial statements are the heart of company analysis and no undertaking of security analysis is complete without in-depth scrutiny of the balance sheet, the income statement and the statement of cash flows.
• The Balance Sheet gives a snapshot of a firm’s assets, liabilities and shareholder equities at a specific point in time.
• The Income Statement gives the history of the operating results over a specific period of time, generally a year.
• The Statement of Cash Flows is a record of the money in and the money out, plus any other events that cause changes in the company’s fiscal position.
The Balance Sheet and the Income Statement will give you the data needed to compute the financial ratios you need for security analysis. The Statement of Cash Flows will illuminate the cash/liquidity position of the company. These documents plus accompanying notes and comments can be found in the Company’s Annual Report.
The reason ratios are so important to the security analysis process is because they are a visual representation of the relationships between the various financial statement accounts. It is important for the wise investor to look at what the ratios indicate about the liquidity, activity, or profitability of the company. Security analysis is all about studying the historical activity of the firm to be able to make predictions about the future.
There are five basic groups of financial ratios. They tell us about:
(1) Liquidity Ratios. Generally this is the Current Ratio and is computed by dividing the current assets figure by the current liabilities figure.
(2) Activity Ratios. These are used to determine how well the company is managing its assets and are the turnover ratios. Accounts receivable turnover is calculated by dividing the annual sales by the accounts receivable, Total asset turnover is calculated by dividing annual sales by total assets.
(3) Leverage. Debt to Equity ratios give you a look at the company financial structure and are computed by dividing the long-term debt by the stockholder’s equity
(4) Profitability. measured by calculating the Net Profit Margin (divide the Net profit after taxes by total revenues) the Return on Assets (divide the net profit after taxes by the total assets) And the Return on Equity (divide the Net profit after taxes by the Stockholder’s equity) and
(5) Common Stock or Market Measures. These measures convert important data about a company to per share information, the most commonly used may be the P/E or Price to Earnings ratio calculated by dividing the Market price of common stock by the company’s earnings per share.
Gitman and Joehnk, in their book “Fundamentals of Investing”, inform us that most investors do not do the math themselves. There are many published reports of current ratios for public companies. Many brokerage houses, financial services firms, and online sources make this material available to the wise investor.
Putting it all together is a matter of comparing historical and industry standards to your target company, examining the competition, and making your assessment of the developing trends within the company, the industry and the economy.
Gitman and Joehnk, 2003, Fundamentals of Investing, Pearson-Wiley Addison
Benz and Dorsey, 2006, Morningstar Complete Investor, Wiley
Hoover Online, http://www.hoovers.com