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Fundamental Analysis: An Investor's Guide

What is fundamental analysis?

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Fundamentalanalysisisthefoundationofsolid
investing.Ithelpsyoudeterminetheunderlyinghealth
ofacompanybyexaminingthebusinesscore
numbers:itsincomestatements,itsearnings
releases,itsbalancesheet,andotherindicatorsof
economichealth.Fromthesefundamentalsinvestors
evaluateifastockisunderorovervalued.
Fundamentalanalysisbeginswithanindividualstock,
butitalsoextendstothatcompanyslargercontext.It
exploresquestionslikethese:Isthecompany
competitivewithinitsindustry?Isthatindustry
growingorshrinking,comparedtoothersectors?
Sharesofcompanieswithstrongfundamentalswill
tendtogoupovertime,whilefundamentallyweakcompanieswillseetheirstockpricesfall.Thismakes
fundamentalanalysisespeciallyvaluabletolongterminvestors.

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Fundamentalanalysisisoneschoolofinvestingresearch.Itcontrastswithanotherpopularapproach,technical
analysis,whichfocusesnotonbusinessfundamentalsbutonstockpriceactionasreflectedincharts.
Technicalanalystslookforrecognizablepatternsinpricechartsthatwillhelpthemestimatethestocksfuture
pricemovement.

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Why conduct fundamental analysis?

Fundamentalanalysishelpsyoudetermineifacompanyisagoodorpoorinvestmentchoice.Imagineyourea
venturecapitalistorabank,whomustdecideifthatcompanyisworthyofaloanorequityinvestment.Howcan
youevaluatewhetherthisparticularcompanydeservesyourinvestablecapital?
Fundamentalanalystsconsiderthefollowinginmakingtheirdecisiontoinvest(ornot):
Isthecompanymakingaprofitconsistently?(Whilethisisnaturallythemostimportantquestionfor
investors,itsimportanttoconsidertheanswerinabiggercontext.Asingleprofitablequarterforanew
companymightbeafluke.Inthesameregard,adropinprofitabilityforanestablishedbluechip
companymightjustbeatemporarysetback.)
Isthatprofitgrowingordecliningovertime?
Isthecompanyholdingitsownrelativetothecompetition?Isitaleaderinitssector?Isthatsector
growingordeclininginimportancetotheoveralleconomy?
Canthecompanypayitsbillsadequately?Ifyouweretodismantlethecompanysoperationstoday,
whatwouldbetheintrinsicvalueofitsassetsversusthevalueofitsdebts?

What information do you need to perform fundamental analysis?

Youcanthinkoffundamentalanalysisasinvestingbythenumbers,sincemuchoftheworkinvolves
evaluatingfinancialstatementsissuedbythecompany.Hereareafewkeystatementsyoushouldlearntoread
andunderstand.
AllpubliclytradedcompaniesintheUnitedStatesarerequiredtofilestatementsoffinancialconditionona
regularbasis.Theseincludethe10Q,aquarterlystatement,andthe10K,anannualstatement.Each
statementfollowsaprescribedformtoincludecertainbasicinformation.
Publiclytradedcompaniesarealsosubjecttoauditsbygovernmentagenciesthatoverseetheirgivenindustry.
Thoseauditsmaybeeitherscheduledorrandomevents.Theresultsofaregulatoryauditmayalsobe
publishedinterestingreadingforawouldbeinvestor.
The10Qand10Karegoodplacestostartyourfundamentalresearch,butyoulllikelywanttodigdeeperinto
thespecifics.Forthatyoullneedtounderstandthreeinterrelatedtypesofstatements:thebalancesheet,the
incomestatementandthecashflowstatement.

Reading a balance sheet: Assets

Asthenamesuggests,abalancesheetpresentsapictureofhowthecompanysassetsthevaluea
companytakesinarebalancedoutagainstitsliabilitieswhatthecompanymustpayout.WhenAssets
equalsLiabilitiesplusEquity,thatswhenthestatementissaidtobeinbalance.
YoucanlookupabalancesheetforanypubliclytradedU.S.stockontheTradeKingwebsiteunderQuotes+
Research>Quotes+News+Research.Justenterthecompanystickersymbolandyoullbeonyourway.In
mostcases,balancesheetsarepresentedinleftandrightsideformat.You'llfindAssetsontheleft,andonthe
rightsideofthepagearetheLiabilitiesandEquity.(Sometimestheseitemsarelistedfromtoptobottom

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insteadoflefttoright.)
Assetsincluderesourcesthecompanyhasthatareworthsomething.Manyoftheseareselfexplanatory,like
Cash&Investments.Othersarelessfamiliar,likeCurrentAssets,whichreferstothevalueofassetsthatare
readilyconvertedintocash,suchasInventoryorReceivables.
Longertermassetsvarydependingonbusinesstype,butmayincludesuchthingsaspropertyorequipment
values.Sincelongtermassetsgraduallydecreaseinvalueovertime,AccumulatedDepreciationissubtracted
fromthis.Notethatdepreciatedassetsmayshowupashavinglittleornovalueonthebalancesheetbutmay
haveamuchgreatermarketvalueifsold.

Reading a balance sheet: Liabilities

Liabilitiesareobligationsthecompanyhasmadetooutsidepartieswhohaveprovidedresources.Inessence,
theseoutsidepartiesmayhavelentmoneyorothersuppliestothecompanyandthereforeareowed
repayment.Itsimportanttonotetheseoutsidepartiesdonothaveownershipinthecompanytheyare
creditors.
ItemsunderLiabilitiesincludeAccountsPayable,theamountthecompanymayowesuppliers,andIncome
TaxesPayable,whichisselfexplanatory.NotethatCurrentLiabilities,whichareshortterm,arelisted
separatelyjustasCurrentAssetsare.Thissectionmayalsocontainlongtermdebtobligations:forexample,if
thecompanyhastakenoutbankloanstofinanceequipmentorrealestate,orifthecompanyhasissued
corporatebondstoinvestors.
AfigurecalledtheQuickRatiohelpsinvestorsdetermineifacompanysassetsandliabilitiesareinahealthy
balance.Thequickratiomeasuresacompany'sabilitytomeetitsshorttermobligationswithitsmostliquid
assets.Thehigherthequickratio,thebetterthefinancialpositionofthecompany.Itscalculatedasfollows:

NotethattheQuickRatioismoreconservativethansomeotherliquiditymeasures,liketheCurrentRatio,
becauseitexcludesinventoryfromcurrentassets.Ifyoubelievethecompanymighthavedifficultyturningtheir
inventoryintocash,thentheQuickRatiomightgiveamoreaccuratepictureofthecompanysshortterm
financialstrength.

Reading a balance sheet: Equity

InafundamentallyhealthycompanyAssetswilloutweightheLiabilities.Thedifferencebetweenthetwois
calledEquity.Again,abalancesheetbalanceswhenAssetsequalsLiabilitiesplusEquity(A=L+E).
Thisbringsustothebottomsectionofthebalancesheet:ShareholdersEquity.Equityiscapitalobtainedfrom
sourcesotherthancreditors.Whatarethesesources?PaidinCapitalreferstomoneyinvestorspaidthe
companyforthestockduringtheinitialpublicofferinginordertobecomeshareholders.PaidinCapitalalso
includescapitalraisedfromanysubsequentofferingsorsaleofnewstock.Keepinmindthisdoesequalnot
thecurrentpriceofthestock.
However,thisdoesnotmakethetwosidesbalance.ThisbringsustotheconceptofRetainedEarnings.
Mathematicallyspeaking,thisistheamountthatmakesthebalancesheetstwosideseven.Putanotherway,
RetainedEarningsreferstotheincomethatsbeenkept(retained)bythecompany.Itsnotapileofcashsitting
somewhereratheritstheamountofmoneythatbelongstotheshareholders,thevaluethecompanyhas
generatedbeyondpaidincapitalandassetsthatexceedliabilities.InvestorsgenerallyliketoseeRetained
Earningsgrowingovertime.
Acompanysbalancesheetgivesusahighlevelpictureofabusiness,butbyitselfittellsusonlysomuch.
BalancesheetsalwaysbalanceAssetswithLiabilitiesandShareholdersEquity.Ittakesdelvingintoincome
andcashflowstatementstolearnmoreaboutthehealthofthecompanyandwhethergrowthistrending
upwardsordownwardsovertime.

Reading an income statement: Revenues and Costs

Theincomestatementgivesamoredetailedanswertoacriticalquestionforanyinvestor:isthecompany
makingmoney?Thewellknownexpressionthebottomlinecomesfromincomestatements.Specifically,it
referstoacompanysNetIncome.Whilethisisobviouslyanimportantfigure,itsworthreviewinganincome
statementlinebyline.Theremaybelittlebitsofgoodnewsorredflagsrevealedalongthewaytocalculating
thatfinalfigure.
TheincomestatementstartswithNetSalesorRevenues,thesocalledtopline.Whenanalystsrefertotop
linegrowth,whattheyreallymeanis:Aretotalrevenuesgrowingorshrinking?Thisisimportantbecauseifthe
toplineisntgrowing,wherewillsustainablegrowthcomefrom?
Thenexttwolinescoverwhatitcostthecompanytoproducetheproductsandservicessold.CostofGoods
Soldcoversdirectcostsofmaterials,labor,etcetera.Depreciation,Depletion&Amortizationisanindirectcost
associatedwithproduction.Forourpurposeswelllumpthemtogether.
AnotherlineitemofcostisSelling,General&AdministrationExpenses.Thesecostspertaintooperatingthe
companyandpromotingtheproduct.AnalystswatchthesocalledSG&Acostsclosely.Problemsoftenshow
upherebeforetheyareapparentinthebottomline.

Reading an income statement: Margins and Earnings

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GrossIncomeiscalculatedbysubtractingcostsfromrevenues.GrossIncomeplaysanimportantrolein
calculatingGrossMargin.Thisratiomeasureswhatpercentageofrevenueisprofitafterweremovethecosts
associatedwithproducingit.
Forexample,ifDriteRiteMotorshad$100millioningrossrevenuesand$70millionincosts,grossmargin
wouldbe70/100=0.7.Inotherwords,thecompanyscosttoproduce$100millioninrevenueis70%ofthat
revenue.GrossMarginreferstothepercentageofthatamountthatsprofit,theremaining30%.
Isa30%grossmargingood?Wedneedtocomparethiscompanysgrossmarginwithitscompetitorsto
benchmarkthisparticularindustry.Itsalsosmarttoconsiderwhetheracompanysgrossmarginsaregoingup
ordownovertime.
OperatingIncomeiscalculatedbysubtractingSelling,General&AdministrationExpenses(SG&A)fromGross
Income.FinancialanalystspaycloseattentiontoOperatingMargin,whichisoperatingincomeasapercentage
ofrevenue.TheyrealsointerestedinProfitMargin(asnodoubtyouare),whichisnetincomeexpressedasa
percentageoftotalrevenue.

Reading an income statement: Earning Ratios

Youllhearinvestorsdiscussingthreeearningsbasedratiosalot:EPS,P/EandPEG.
EarningsPerShare(EPS)thisreferstothetotalamountacompanyearnedinagiventimeframe,dividedby
thenumberofoutstandingshares.EPSisoneofthemostquotedindicationsofacompanyscurrenthealth.
PricetoEarningsRatio(P/E).Sinceyourebuyingashareofthecompanytogetashareoftheirearnings,you
shouldwanttoknowhowmuchyourepayingforthatprivilege.P/Ecanbeahandyyardstickforwhetheryoure
payingdearlytotapacompanysearningsstream,orwhetheryouregettingabargain.
P/Eiscalculatedasfollows:youtakethepriceofthestockanddivideitbytheEPS.P/Eisalwaysquoted
usingannualearnings.
WhatshouldP/Ebe?Again,numberslikethesearerelativetothecompanyssectorandcurrentmarket
conditions.YoushouldcompareyourcompanysP/Etothatofitschiefcompetitors,andthencheckoutthe
averageP/EfortheS&P500.
Price/EarningstoGrowth(PEG).WhenyoustartcomparingtheP/Eratiosofvariousstocks,youmayfindit
confusing.XYZhasaP/Eof59ABChasaP/Eof12.DoesthatmeanXYZstockisoverpricedandABCsis
abargain?Maybe.Whydoesn'tthemarketestablishwhattheP/Eratioshouldbeandadjustallstockprices
accordingly?
Theshortansweristhatearningschange,andindividualstockpricesaredeterminedbytheexpectationof
futureearnings.Bycontrast,P/EandEPSgiveusonlyasnapshotinthepast.Anotherproblemisintheway
companiesreportearningsandthewayinwhichthemarketinterpretsthem.Ifacompanyhasa"onetime
chargeagainstearnings"forsomeextraordinaryreason,thislowersEPS.However,themarketmayfocusmore
onwhatearningswouldhavebeeniftheonetimechargewereignored.
Sohowshouldwecomparethesenumbers?EnterPEG,anearningsratiothattriestoaccountforfuture
growth.ItscalculatedbytakingtheP/EratioanddividingitbytheannualEPSgrowthrate.PEGisawidely
usedmeasureofvaluation.APEGofonesuggeststhestockisfairlyvalued.Ifitsgreaterthanone,thestock
maybeoverpriced.Iflessthanone,thestockmaybeundervalued.PEGisusefulinevaluatinghighgrowth
stocks,becauseeventhoughtheircurrentearningsmaybemodest,theexpectationisthatthesecompanies
arepoisedforpotentiallyexplosivegrowth.

Reading a cash flow statement: The Big Picture

Thecashflowstatementhelpsinvestorsanswerquestionslike:Isthecompanygeneratingenoughcash
neededtofundgrowth?Isgrowthoutpacingcashgeneration,requiringadditionalfinancing?Isthecompany
generatingenoughcashtocoveritsshorttermneeds?
Intimesofeasycredit,companiesmaybeabletopatchovercashflowinterruptionswithinterimfinancing
duringtightercreditmarkets,though,suchfinancingmaynotbeasreadilyavailable.Inthosesituations,steady
cashflowgeneratedbythecompanysoperationsbecomesespeciallyimportant.
Therearethreebigcategoriesofcashflowtopayattentiontohere.Wordofwarning:itsnotalwayscrystal
clearfromjustglancingatacashflowstatementwhichlineitemsrepresentcashflowingINversuscash
flowingOUT.CashgeneratedbyandusedbythecompanysoperationsissummarizedintheNetCashFlow
OperatingActivitiesline.Thatlineincludescashflowinginaswellascashout.
ThecompanyslongterminvestingofcashisdetailedintheNetCashFlowInvestingline.Thatconsistsof
cashflowingout.Thethirdandlastpart,theNetCashFlowFinancingline,showsthecashacompany
raisedthroughfromfinancingactivities.Thatscashthatcamein.
Theverybottomlineshowsthenetchangeinthecompanyscashposition.Ifyouaddthelinetothecashon
thebalancesheetfromthepreviousyear,youllgetthecurrentcashpositiononthecurrentyearsbalance
sheet.

Reading a cash flow statement: Operating Cash Flows

Thatsthetoplevelofcategories,soletsdigintothespecificsabit.ThecashflowstatementstartswithNet

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Income,afigurewhichcomesfromtheincomestatement.YoullnoticenextDepreciation,Depletion&
Amortizationisaddedbackin.Thesecostsimpactthecompanysprofitabilitybutarent,literallyspeaking,
cashflowsoutofthecompany.Youcouldsafelycallthesepaperlosses.
Depreciationisdeductedwhendeterminingacompanysnetprofit,becauseitsassumedthatthethingsbeing
depreciatedhavelostvalue.Therestofthetopofthestatementprovidesamoredetailedexplanationasto
wherecashcamefromandwasusedinoperations.
ThingslikeachangeinAccountsPayableandInventorycanchangethecompanyscashposition.For
example,thislineitemwouldincludethingslikebillsthecompanyhasntyetpaidthatscashthecompany
stilltechnicallyhasonhand.Anotheritemyoumightnoteinthissectionisincreasesininventory,whichcosts
thecompanysomecash.ThesubtotalforNetCashFlowOperatingActivitieswillusuallybeapositivefigure,
indicatingcashflowingin.

Reading a Cash Flow Statement: Investing and Financing Cash Flows

Ifthecompanytakesonnewfixedassetslikeequipmentoradditionalplants,thatsanexampleofinvesting
basedcashflows.Theinvestingsectionofacashflowstatementmayalsoincludenewassetsacquiredduring
amerger,disposaloffixedassetsthatwerepreviouslyonthebooks,andotheritems.TheNetCashFlow
Investinglinewillbeeitherpositiveornegative,indicatingwhethernetcashflowedoutorinduetoinvesting
activities.
Whenwetalkaboutcashflowsfromfinancing,keepinmindthatfinancingmightmeancashiscomingin,if
thecompanytakesonnewdebt,orflowingout,iftheychoosetopaydowndebts.Thefinancingsectionofthe
statementmayalsoincludecashdividendspaidouttocommonorpreferredstockholders,purchasesor
conversionsofthecompanybuyingitsownstockontheopenmarket,theeffectsofforeigncurrency
fluctuationsandotheritems.Again,theNetCashFlowFinancinglineiseitherapositiveornegativenumber,
tellingyouwhethernetcashflowedoutorinduetofinancing.
Acashflowstatementmayfeellikeadryrecordofcashshuntingfromtheplustotheminuscolumnsandback
again.Itsonlyincloserinspectionandcomparisonofstatementsovertimethatinterestingdiscrepanciescan
revealthemselves.Forexample,saywhilecomparingcashflowstatementsforacompanyoverseveralyears,
younoticeasizeablejumpinacompanysReceivablesitem.Thismaysimplybeanaccountingchangeand
notmeanmuchinrealterms.However,ifthatsnotthecase,ajumpinAccountsReceivablesmightmeanthe
companyishavingahardertimecollectingfromitscustomersanimportantshiftthatthecompanywill
naturallynotseektoadvertise.Itsnuggetslikethesethatrewardthepatientworkofaninvestorwillingtodig
throughfinancialstatementstofindpotentialredflagsoropportunitiesunseenbythelessobservanteye.

Fundamental analysis tools at TradeKing

YourfirstsourceoftoplineinformationaboutastockcanbefoundunderQuotes&Research>Stocks>
Quotes.(DontforgettologintoyourTradeKingaccountfirst.)Afterenteringinyourstockstickersymbol,
youllfindEPSandP/Eratiosrightonthesummaryquotespage.
ClickontheFinancialsTabtoaccessall3ofthefinancialstatementsdiscussedhere:incomestatement,
balancesheetandcashflowstatement.Quotes&Researchincludeslotsofothergreatdataforfundamental
analysts,sobesuretoclickaroundandseewhatelseyoufind.
Don'tforgettocheckouttheS&PStockReports.Justenteratickersymbolorcompanyname,andyouwillbe
abletoaccessthemostrecentstockreportonthatcompany.TheS&PStockReportsprovideobjective
analysisandopinionsonapproximately1,500companiesusingBottomUpAnalytics.Standard&Poor'sglobal
teamofequityanalystscreateacomprehensivecorporateoverviewincludingS&PSTARSrecommendations.

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