Follow the Money Using Fundamental Analysis - dummies

Follow the Money Using Fundamental Analysis

By Matt Krantz

One of the basic rules of investigative journalism is following the money, and you do the same in fundamental analysis for investing. Tracing the movement of dollars through an organization will quickly show you the motives of the leaders, availability of resources, and vulnerabilities. Regulators will often follow the movement of money to pinpoint illegal cartels, Ponzi schemes, and other frauds.

All this might sound very cloak-and-dagger. But there’s something to be learned from approaching fundamental analysis with the mind of an investigator. Your job is to take available information and dig up data yourself to get a complete picture of a company and whether or not it’s a suitable place for you to entrust your money. Following the way money moves through a company will tell you more about it than just about anything else.

While no two companies are the same, the basics of business are universal. That’s why fundamental analysis is such a powerful tool you can apply to high-tech companies, low-tech companies, and everything in between.

Companies are merely in the business of selling things they acquire for more than what they paid. Sounds simple. But that can be easy to forget after you get mired in details like profit margins, earnings per share, and P-E ratios.

Following the money at a company, so to speak, traces a predictable cycle. Just like the cycle or life repeats and refreshes, companies follow a pretty predictable pattern, too. Fundamental analysts call this the trade cycle — and understanding the cycle is pretty important if you want the financial statements to make sense.

The trade cycle begins with a business idea, but more specifically it starts when a company raises money so it can buy the equipment it needs to get started. Money might be raised by borrowing it, called debt, or by lining up investors willing to bet their money for a piece of future profits, called equity. The money raised is then used to acquire raw materials, office space, or whatever the company needs.

Next, the company tries to add value to the raw materials in some way and sell the product to customers. Typically, companies will also incur indirect costs, or overhead, to make all this happen. Overhead costs include everything from advertising, to research and development, to hiring skilled managers. The products are created and (hopefully) sold to the consumers. The cash collected from customers is then used to repay debt. The cycle then repeats all over again. Isn’t this fun?

Now here’s where fundamental analysis comes in. Here are a few questions a fundamental analyst might ask when taking a look at a company:

  • After factoring in all the costs, did the company make money?
  • How much money did the company raise to get started?
  • Is the company able to maintain itself without borrowing more or getting more investors?
  • Can the company create new products to keep buyers coming back?
  • Are competitors catching onto the idea and selling a similar product for less?