The Fundamental Analysis Toolbox
One of the great things about fundamental analysis is that you don’t really need much to get started. If you have a computer and calculator, you’re pretty much set.
Unlike technical analysis, which may require sophisticated and costly stock chart services, most of the data you need for fundamental analysis is provided free from nearly every company. Plus, many free online services offer increasingly detailed access to company financial data, making it easy for you to download and analyze. There are three key financial documents that are the cornerstone of financial analysis: the income statement, balance sheet, and statement of cash flows.
Introducing the income statement
Want to know how much a company made or lost during a year or a quarter? The income statement is for you. This financial statement steps you through all the money a company brought in and how much it spent to make that money. If you’ve ever read news stories about how much a company earned during a quarter, for instance, the information was taken off the company’s income statement.
The income statement is the financial statement containing data you probably hear the most about, including revenue, net income, and earnings per share.
Want to know how much money a company has or how much it owes to others? That’s where the balance sheet comes in. This financial statement spells out all the cash a company has in addition to its debt. The difference between what a company owns (its assets) and what it owes (its liabilities) is its equity. The basic formula is:
Assets = Liabilities + Equity
Sometimes it’s helpful to understand corporate-finance jargon by putting it in personal-finance terms. If you’ve ever calculated your personal net worth by subtracting all your loans from all your savings, you’ve essentially created a balance sheet.
The figure shows a favorite way to look at the relationship between assets, liabilities, and equity. Think of the company’s financial position as a square. Next, cut the square in half. The left-hand side of the square, which we’ll call assets, is worth the same as the right-hand side of the square, which we’ll call liabilities and equity. The left-hand side of the square must always equal the right hand side of the square. Remember that liabilities and equity don’t have to equal each other, but they do together must equal the assets.
Getting the mojo of cash flows
One of the first things fundamental analysts need to understand is that earnings aren’t necessarily cash. Accounting rules, for instance, allow companies to include in their income statement revenue from products they may have sold to consumers, but haven’t actually collected dollars from customers yet. Yes, you read that right. A company might say it earned $100 million, even though it hasn’t collected a dime from customers. This method of accounting, called accrual accounting, is done for a good reason. Accrual accounting lets analysts see more accurately how much it cost a company to generate sales.
But accrual accounting makes it critical for investors to monitor not just a company’s earnings, but how much cash it brings in. The statement of cash flows holds a company’s feet to the fire and requires it to disclose how much cold, hard cash is coming into the company. The statement of cash flows lets you see how much cash a company generated from its primary business operations. The statement, though, also lets you see how much cash a company brought in from lenders and investors.
Familiarizing yourself with financial ratios (including the P-E)
While the financial statements are enormously valuable to financial analysts, they only go so far. Not only do companies tend to only give the information they’re required to, the data can only tell you so much. You didn’t expect companies to do everything for you, right? That’s how financial ratios can be very important.
Financial ratios take different numbers from the income statement, balance sheet, and statement of cash flows, and compare them with each other. You’ll be amazed at what you can find out about a company by mixing numbers from different statements. Financial ratios can provide great insight when applied to analysis.
There are dozens of helpful financial ratios, which you can read about in more detail in Chapter 8. But at this point, you’ll just want to know the basic flavors and ratios and what they tell you, including:
- Valuation: If you’ve ever heard of the price-to-earnings ratio, or P-E, you’ve used a financial ratio. The P-E is one of many valuation ratios. Valuation ratios help fundamental analysts find out if a stock is cheap or expensive by comparing the stock price to a basic piece of data about a company. For instance, the P-E ratio compares a stock’s price to its earnings. The higher the P-E, the more richly valued a stock is.
- Financial health: If a company is no longer a going concern and isn’t functioning, it’s not a great idea to invest in it. Some ratios, called liquidity ratios, measure how easily a company is able to keep up with its bills. Fundamental analysts will look for red flags that a company might be about to face some tough times.
- Return on investment: If you’re going to give your money to a company, either as a loan or investment, you want to make sure you’re getting enough in return. Return on investment ratios help you determine how well the company is putting your money to work.
- Operating performance: The more a company can increase its sales, while at the same time lowering costs, the more profitable it is. This balancing act is the essence of business. And the stakes for investors are huge, because the more profit a company generates, the bigger piece of the pie that’s left for investors. Operating performance ratios let you quickly see how well a company is managing its costs and increasing sales.
All the types of ratios and financial measures above are best understood when put into context. Fundamental analysts typically compare financial metrics to those of a company’s rivals. It can be useful to have financial data not just on the company you’re interested in, but on the industry for comparison.