FA Education: (some specific rules of thumb)
FUNDAMENTAL ANALYSIS
At its broadest, Fundamental Analysis studies any data that might be expected to impact the price or perceived value of a stock, other than analyzing the trading patterns of that stock itself.
Fundamentals include economic factors, industry-specific trends, capital market conditions, and company-specific data and qualities. Within fundamental analysis lie the equally broad concepts of quantitative analysis, where economic or company-specific numerical data are analyzed with computer software and other objective means, and qualitative analysis, which examines less tangible concepts such as technology strength and management effectiveness.
Quantitative Factors
A wide range of ratios are used in fundamental analysis, including such income statement data as Sales, Operating costs, Pre-tax profit margin, Apparent tax rate, Net profit margin, Return on equity (ROE), Cash flow, and Earnings (or Income) per share (EPS). On the balance sheet, quantitative measures include various asset and debt ratios, as well as the capital structure of the company.
In brief, some common company-specific fundamental quantitative measures and their basic calculations are as follows:
Balance Sheet Ratios
Working capital (current) ratio: current assets / current liabilities; a higher number is generally good, although a ratio higher than 5:1 may indicate an unnecessary accumulation of funds or inventories.
Quick ratio: (current assets – inventories) / current liabilities; removing inventories from the Current ratio determines the company’s ability to pay down debt with liquid assets (cash) at a moment’s notice.
Asset coverage: Shows the net tangible assets of the company per $1,000 of total debt outstanding; usually a company should be possess at least $1,500 to $2,000 of net tangible assets for each $1,000 of debt.
Debt-equity ratio: total debt outstanding / book value of equity; generally a company should not have more than half to 1 ½ debt to book value.
Interest coverage: Measures the company’s ability to pay the interest on its debt with its earnings; most companies should have earnings covering at least two to three times its interest payments in any given fiscal year.
Dividend coverage: Adds dividends to the denominator of the Interest coverage ratio, such that the Dividend coverage ratio measures the ability of a company to pay both interest AND dividends from its earnings.
Income Statement Ratios:
Profit margins: Gross profit margin is calculated as (net sales – cost of goods sold) / net sales; and indicates the company’s efficiency in turning over (selling) goods at a profit. Operating profit margin and Net profit margin are calculated similarly to gross profit margin, but consider net sales after taxes, and net earnings respectively, in the numerator of the equation.
Return on equity: One of the most important ratios for common shareholders, return on equity is calculated as net earnings / common equity. Return on equity demonstrates the level of profit that the company has generated from common shareholders’ equity.
Value Ratios:
This class of ratios considers the market price of a stock in relation to various data from the company’s financial statements. Value ratios are the best determinants of the market’s collective opinion of the inherent value of the company.
Price-Earnings Ratio (PE Multiple): Current market price / earnings per share (latest 12 months); the PE ratio is perhaps the most common measure used to compare stocks within particular industries and over time, and is probably the most useful, as it effectively combines all other ratios in one figure. PE Ratios are often based on analyst projections of a company’s earnings for the subsequent 12 month period, or longer.
Qualitative Analysis:
Qualitative factors include any given number of “intangible” factors that cannot easily be measured with numerical data (although analysts will often attempt to apply numerical measurements to intangible data to try to standardize intangible measures across different companies).
Some examples of qualitative measures include:
Product or innovation: Asks product-specific or marketing questions such as: Does the company possess proprietary technology? Patent protection (proprietary technology adequately protected)? Acceptance of product/service (industry awards, customer testimonials)? Is the market a niche market?
Marketing innovation: Are distribution channels in place? Focused sales/marketing plan that is logical and acceptable? Potential for recurring revenue? Are there sustainable barriers to entry, and what are they?
Quality of management: Poses questions such as: Are the principals capable and driven to succeed? Appropriate education levels? Prior entrepreneurial successes? Relevant business experience? Past public company experience? Strong technology understanding/background?
Conclusion:
Any comprehensive company analysis will take into account all of the factors described above (assuming they’re all applicable to the company in question). Further, there are endless variations on each of these measures, not to mention dozens of additional, equally important fundamental measures in common use.
Analysts may choose to focus primarily on fundamental analysis and largely ignore technical indicators (measures specifically derived from stock trading patterns), or they may choose to weigh their analysis toward on technical factors. In practice, most analysts would use a combination of both fundamental and technical analysis to derive the most complete picture as is possible in regard to a potential future stock price. |
