There are many ways on how one would perform fundamental analysis on companies before he or she invests. It can be an extremely in-depth research, which is mostly recommended if you are unfamiliar with the company and you are purchasing it for the first time. It always pays off to know more than less but it can be very consuming at times. In this post, I will show a quick bread and butter methodology on how you can perform fundamental analysis research on selected companies for the shortest time with the greatest result.
You might recall that one of Benjamin Graham’s rule in finding an undervalued stock includes pricing its entry price at least a third below its intrinsic value. For me, I usually place a stricter first round screening criteria towards my stocks filtering exercise which is the first step in identifying solid companies, perform some background analysis on the strength of the companies, and then review if the current market price represents a fair (or better undervalued) value to enter.
There are many investors who perform fundamental research solely based on the popular methodology of Price to Earnings valuation alone. It is fine if you find the strategy happens to work for you in the past but do take note that it does not represents the strength of the company in terms of balance sheet, which will be discussed in greater details later.
Anyway, here we go. These are some of the fundamentals I usually look out for:
1.) Earnings Yield vs Free Cash Flow Yield vs Dividend Yield
Most of the stock market movement revolves around a company’s earnings.
A positive earnings show profitability and this eventually adds up to the retained earnings under the equity portion, which increases the net asset value of the company. The basic measurement of earnings is earnings per share (EPS), which you might have heard analysts throw that around as well as the Price to Earnings Ratio (PER), which is what investors gauge by measuring how much price multiple does one pay for the earnings. Obviously as an investor, you would want to pay as low price multiple to earnings as possible, caveat applies. Earnings Yield is the exact inverse version of the PER. The greater the earnings yield, the faster the justification to earn that capital back you have put into the company.
A value investor doesn’t usually look at simply the earnings yield but go one better by looking at the company’s free cash flow yield. This is taken by looking at the cash flow statement under the Cash Flow from Operating (CFO) section less the capital expenditure which you can find under the Cash Flow from Investing (CFI).
Positive Cash flow which ultimately increases the net equity of the business is what every company strives to achieve at the end of the day. Free cash flow, a subset of cash flow, is the amount of cash left over after the company has paid all obligations of their working capital and capital expenditures. A company that has free cash flow yield very close to the earnings yield imply that the company’s nature of business is not capital intensive and this could work much to their favor because more earnings are converted into equity.
The final highlight to watch out for is to ensure that the dividend yield the company distributes is less than the free cash flow yield and earnings yield so that the company has sufficient retained earnings to grow the company through acquisition or asset accumulation. Too many investors are blinded by the dividend yield that they often ignore this point which may come back to haunt them in the future.
A quick recount on the head shows that companies such as SATS, SPH and Neratel distributes dividends that are often more than the earnings yield, not even to mention the free cash flow yield. This is a red flag that investors need to take note of as this will reduce their retained earnings and eventually weaken the balance sheet of the company.
2.) Return on Equity
The Return on Equity (ROE) is a very important metric that accounts for how much equity return the company gets in return for each unit dollar of money that they put in as capital.
It measures a company’s ability to generate profits based on the amount of money (or equity earnings) shareholders have invested. They can be derived by simply taking the net profits of the company divided over the equity portion. The higher the ROE, the better the management has managed to generate return for shareholders. However, there is one caveat you need to take note.
As an investor, you might want to refer to a Dupont identity of the ROE which is simply an extended version of the normal one. This is a very powerful metric because it takes into account the strength of the income statement and balance sheet combined together. A Dupont ROE can be derived from:
This measures the profitability margin of a company.
The profit margin is an accounting measure designed to gauge the financial health of a company. It can be derived by taking in the ratio of profits over sales. Obviously, you want this figure to ramp up as high as possible but it really depends on the moat of the company or items they are selling. The higher they can mark up their products, the higher the profit margin for the company.
Asset Turnover Efficiency
This measures the ability of the company to generate sales based on each unit of asset the company owns.
This can be derived by taking sales divided over by the total asset. You want to get this figure as high as possible because it is in the interest of the company to generate as much sales as possible with the asset they have in their books.
Different industries however, have different expectations of the asset turnover ratio. For example, the asset turnover ratio tends to be higher for companies in a sector such as consumer staples, which has relatively small asset base but high sales volume. Conversely, in industries such as utilities or machineries, they usually generate lower ratio.
The multiplier acts in the form of leverage and this could work to the company’s advantage if they are able to prudently use borrowings to multiply over their returns on equity.
A high ROE that is derived through the multiplier should be seen as a red flag, as this indicates that the company earns the return through the use of leverage more than what they are capable of generating in terms of profit margin or asset efficiency.
3.) Balance Sheet
If you are a risk adverse investor, the first thing you should always look out for is the balance sheet statement of the company. It tells you what and where their current strengths and weaknesses are at the point in time.
There are some hints that you could draw from the balance sheet as well:
Cash less Debt/Borrowings
This is more than just measuring the net gearing of the company as it emphasizes specifically on liquid cash and borrowings. Generally, I like to see justifications on what the company is doing for taking on the leverage. There may be a need to delve further to gain a deeper insight of what the company is using the borrowings for. Otherwise, I’d rather see a net cash company than not, everything else equal.
Some companies that are under the commodities business selling raw materials for example will have their balance sheet full of intentories or PPE. Depending on how you interpret the situation, you can see decreasing inventories as an indication that the management are seeing a slowdown in the business or vice versa. The other interpretation could be that their inventories are piling up and sales are decreasing. There are many hints that you can analyze to and from.
Cash Conversion Cycle
The reason why I have left it here is because this is directly linked to the working capital of the company through the cash conversion cycle metrics.
The main things to look out for is the Days of Sales Outstanding (DSO) and Days of Payables Outstanding (DPO). The general rule of thumb is companies like to delay payments made to vendor for as long as they can and receive money from customers for as fast as they can. I have seen many companies that focuses a great deal just on this alone.
So that is it.
3 basic fundamentals that I have frequently used to analyze a company before proceeding further on whether it is a worthy investment or if the price is fair. As always, I’d rather pay a fair price for a great company than a good price for a fair company. The choice is yours.
What about you? How did you do your fundamental analysis? Any metrics that is missing from up there you think is important?