Fundamental analysis is an important tool that traders can use to increase their probability of success. I have found that fundamental analysis provides real value when making trading decisions. Understanding the financial position of a company can provide additional confirmation for any trade you are considering, or it may make you rethink the wisdom of that trade.
Many traders frequently seem to ignore fundamental analysis, relying instead on technical analysis or just market intuition. Their justification is that fundamental analysis is primarily for the long-term and that it does not help with shorter-term trading. My response would be: “If you’re planning to still be trading next year, then you’re a long-term trader”.
I think the real problem people have with fundamental analysis is that it involves a lot of subjective judgments and does not give the clear buy and sell signals you receive from technical analysis. My feeling has always been that it is better to have bullish positions on financially strong companies and bearish positions on financially weak companies than the other way around. And the truth is that the research needed is not that time consuming, and goes faster the more you do it. Let me walk you through the steps I use to get a quick idea of the general financial picture and likely prospects for a company.
The first step in every analysis is to understand current conditions and trends in the economy as a whole. This gives you a framework to work within. Here you determine if overall economic conditions are good for the company, as well as the industry they operate in. Some of the most important economic indicators are inflation, employment, interest rates, GDP growth and productivity, as well as consumer spending and business investment.
The government or other organizations supply reports on all of these periodically, and these reports very often move the market. What you want to think about is the future prospects for the company’s industry or sector. The conditions in the industry will influence the outlook for the company. Even well managed companies will have poor returns if they are in a struggling industry. If you are considering a bullish position, a weak stock in a strong industry is often better than a strong stock in a weak industry.
After looking at economic and industry conditions, it is time to analyze the company itself and get an idea of its financial health and value. This is the part that scares most traders off, as they envision hours spent studying financial statements. But it is not that time consuming to check a few major financial numbers and ratios. You can easily get much of your research from professional sources (often free) that will give you a good fundamental picture of a company. Why do it yourself when others have already done it?
A profile and most of the important financial data and ratios is available free for almost any company on many financial websites such as TheStreet.com, Yahoo Finance, or MSN Money. Here you can quickly get an idea of the company’s business, their profitability, enterprise value, liquidity, leverage, and efficiency. There are a lot of financial ratios that, if understood, convey a lot of information. Below are a few of the most important financial ratios with a brief explanation of each:
Net Profit Margin
: To calculate a company's Net Profit Margin, you divide Net Income by Total Sales. This ratio tells you how much profit they receive from each dollar of sales. If you were looking at Microsoft, for example, you would notice that their Net Profit Margin has declined from around 40% to 30%, while the application software industry as a whole has declined from 20% to near zero the past couple years.
P/E Ratio: The Price/Earnings ratio is calculated by dividing the current stock price by a company’s annual Earnings Per Share and shows how much you must pay to buy a dollar of a company's earnings. Expectations of a company's future performance play a big role in determining the current P/E ratio, and you should compare P/E ratios for companies in the same industry. All else equal, a lower P/E ratio means a better value.
Book Value/Share: Book value is calculated by dividing a company’s Total Net Assets (assets minus liabilities) by the total number of shares outstanding. Depending on the accounting methods used, and the age of the assets, book value can be helpful in determining if a stock is over or under priced. A stock that is priced far below its book may be an indication that it is under priced.
Current Ratio: The current ratio measures liquidity, and is calculated by dividing Current Assets by Current Liabilities. This ratio gives you a sense of a company's ability to meet its short-term liabilities with liquid assets. A ratio of 1 implies adequate coverage and the higher above 1 the better. I consider a ratio over 2.0, or in line with industry averages, a good number. If it is relatively low and declining, that is a bad sign.
Debt Ratio: A company's debt ratio is calculated by dividing Total Liabilities by Total Assets. It is a measure of leverage, and tells you the extent by which a company’s assets have been financed with debt. For example, a debt ratio of 40% indicates that 40% of the company's assets have been financed with borrowed funds. Debt can be good or bad. In times of economic stress or rising interest rates, companies with high debt ratios can experience financial problems. During good times, debt can enhance profitability by financing growth at a lower cost.
Ratios should always be compared to other companies within the same industry to get a feel for what is normal for that business. The financial data and ratios you will see on the financial sites come directly from a company’s financial statements. Quarterly and annual statements for public companies are required to be filed with the SEC. These reports can be accessed online easily if you want to do further research, and annual data is always available in a company’s annual report. The most important financial statements are the Income Statement, Balance Sheet, and the Statement of Cash Flows.
If you do take the time to look at financial statements, keep in mind that they are written and paid for by the management of the company. The auditors are paid by management to present financial information in a way that makes the firm look as good as possible, within the broad limits of Generally Accepted Accounting Principles. If they didn’t, they would be replaced, just like any other employee that disobeys the wishes of management.
Even so, they are still the best source of financial information available. Analysts spend hours tearing these statements apart, calculating ratios, and comparing this year’s results with prior years and other companies in the same industry. That kind of research does take a lot of time. But for the average trader, there are only a few critical financial numbers you really need to look at. So let’s look briefly at each of the major financial statements, point out the most important numbers, and perform a few simple calculations.
Earnings are a fundamental component in valuing a company, and the Income Statement is the basic record for reporting a company's earnings. It gives you a picture of how well the company has prospered over the past year. The best companies will show positive earnings that have risen steadily over time. It is possible to show smooth increases in earnings over a few quarters, or even years, by using the best allowable accounting practices. So for those interested in looking a little deeper I would suggest they also look at Sales, Gross Profit (or Operating Income), and Net Income.
Naturally, sales are important to any company. You can also calculate a company’s rate of growth by taking this year's sales and dividing by last year's sales. You need sales to generate income, and it may seem that more is always better. But you might also want to take a look at the Cost of Sales. Increasing sales is good, but only as long as each additional sale generates more revenue than it costs to produce it.
Gross Profit is Net Sales minus the Cost of Goods Sold (before taxes). If you divide Gross Profit by Sales, then you get a company’s gross profit margin. This key performance indicator tells you whether the company’s mark up on goods and services is allowing the company to cover their expenses and make profit.
Finally, the Net Profit line is very important. If you are looking at a bullish trade, you want to see this number positive and increasing. If you are looking at a bearish position, negative and decreasing is ideal. However, Net Profit is a result of many things, not just the company’s operations. By looking over the Footnotes and Auditor's Letter you may get a better idea of just how much confidence you can put on this particular number.
Inventory Turnover: This efficiency ratio is calculated by dividing the Cost of Goods Sold by Inventory. It tells you how effectively a company manages its inventory and shows the number of times inventory is turned over each year. What a good reading would be is dependent on the industry. For instance, a discount store like Target will have a much higher turnover than an airplane manufacturer such as Boeing.
The Balance Sheet is divided into three sections and allows you to see how conservative the firm is with its assets as well as how efficiently it is using them. The Assets section shows what the company owns. Liabilities are what the company owes. The third and final section is Shareholder's Equity. This is essentially the "net worth" of the company. Important lines to look at would be Current Assets, Current Liabilities, and Total Assets.
The word “current” on the balance sheet refers to assets and liabilities that are equivalent to, or will be turned into, cash over the next year during the normal course of business. Receivables will be collected, inventory sold, and the pre-paid expenses used. When Current Assets are greater than Current Liabilities, there should be no trouble meeting obligations with cash collected from the various accounts. A large positive difference in these two numbers is good, while seeing Liabilities that exceed Assets is bad.
The final number to look at on the Balance Sheet is Total Assets. Dividing Net Income by Total Assets gives you a company’s Return on Assets (ROA). This is a measure of how efficiently management uses the company’s assets. I use ROA to get a more accurate picture than is given by the more commonly used Return on Equity (ROE).
While ROE is directly related to ROA, ROE is adjusted for the amount of debt assumed. That means management can increase ROE simply by borrowing more. But that does not help the company do better operationally, and total profit decreases as additional funds are used to pay the interest. In tough economic times the increased leverage may become critical. There is no “correct” level of debt, but always check that the overall financial structure of the company makes sense for its industry.
By now, you should be getting good a picture of how fundamental analysts evaluate a company, and it can be as much an art as it is science. There are many different ways you can legitimately account for assets, liabilities, income, and expenses, and different industries have different standards. Plus, companies use an accrual accounting system that can sometimes misrepresent or distort the true financial position of the company.
That is what makes the last financial document we will look at, the Statement of Cash Flows, so important. This statement converts accrual accounting back to a cash basis, which let’s you see actual cash movements. After all, if a company needs to generate enough cash from operations to pay for those operations. It also lets you see how much free cash flow they can deploy to other uses such as new investments, repaying debt that was previously borrowed, or to pay dividends to stockholders.
The Net Cash Provided by Operating Activities should always be positive, and the next section, Investing Activities, should not always be negative. A negative number here is fine, if you know the company is undertaking major expansions. But it should turn positive after a few years. Finally, look at the Financing Activities section to see how the firm pays for its cash needs. Is it issuing debt and adding risk, or selling additional equity and diluting the shareholder's position? A mature company should be repaying past borrowings. Remember, there is no right or wrong answer to any of these categories; you are just trying to get a general feel for the company’s health.
Options traders often enter trades with a directional bias, and it helps to have as much information as possible about the company. While the stock price may not directly track with the current state of the company, there is no doubt that fundamental factors play a major role in a stock's price. The stock price of successful companies will go up and the stock price of failing companies will go down. Taking a little time to understand the economic and industry conditions the company is operating in and checking the financial health of a company will give you a feel for how successful that company is likely to be. That allows you to enter trades that will likely have a higher probability of success.
To bring fundamental analysis into your trading you don’t have to spend hours studying the annual reports of every company. Using this kind of streamlined analysis lets you increase your chances for success while still making quick decisions.
Like anything else, your first attempts to read financial statements may seem overwhelming but with a little practice it becomes much easier. Fundamental analysis may mean more work, but that is also its appeal. The time needed to analyze a company’s fundamental condition and future prospects causes many traders to skip this step. However, when you do take a position in a stock that represents a good value, it gives you confidence and helps insulate you from the day-to-day whims of the market.