Fundamental Analysis – Advanced
We now deal with some more advanced aspects of Fundamental Analysis. This incorporates what is called ‘financial analysis’ and accounting, in order to better understand the company and try to calculate the ‘real value of share’.
Before we dive in, it is worth a brief aside in order to put a lot of this into perspective.
Deep fundamental analysis involves research, a basic understanding of accounting practices, financial analysis, understanding the internal and external environment a company operates in, and a number of useful financial ratios which have to be calculated. Many people will want to know how necessary all of this research is every time you want to buy a share, especially since this can amount to a reasonable amount of work and time. Well, a good question. The short answer, according to me, is no – you don’t have to do all of this work in order to focus on Fundamental Analysis.
However, it is useful to have a basic understanding and working knowledge of fundamental analysis and what it entails, as it adds valuable ammunition to the arsenal of skills you are building up a s a stock trader. At the very least, you should know what it is you are not doing or missing out on if you skip certain steps.
So – before we move on to more fundamental analysis, let’s look at why we are doing some of these calculations in the first place. From a fundamental analysts point of view, which is longer term to start with, the share price is dependent on expectation of improved profits which leads to higher dividends. This may not be important to you personally if you aim to use the stock market as a vehicle for capital growth, however, you are not trading in isolation – and there are numerous people out there that invest for profits and dividends, which in turn impacts the share price. Greater profits, better earnings per share, more dividends… a better share price and a better off shareholder. Fundamental analysis, and financial analysis in particular, is basically concerned with calculating the ability of a company to make profits. This is done by looking at the current situation as well as trends in the external environment (for example, the economy), the internal environment (for example the accounts) and the profitability ratios (which we cover in more detail later). Ratios can tell you what sort of return the company typically makes (now, in the past, and compared to other similar companies), as well as how some factors can affect the company’s profits in the future.
So – some knowledge of a company’s financial position is useful. At the least, you should know the following about a stock before you invest in it.
- The more that is known publicly about a company and the more that well-known analysts look at the company, the more you might be able to rely on their figures, but come to your own conclusions. If little is known about the company, do as much research as you can.
- The Financial Year-End and earnings announcements dates – This is important as large price movements can be expected at key points in time.
- D.R. (Last Day to Register for Dividends)
- Earnings Yield – is the share highly rated, with a low yield?
- The Level of Borrowings in the Company – the level of gearing of the company will help you understand how it will respond to changes in the interest rate and the business cycle.
- The Profit Trend over the last few years – you can quickly see whether the company is growing and is achieving steady profits over time, or if it is declining.
Let’s now take a look at some key ratios that are commonly used to depict a company’s current status, comparative status against other similar companies and the sector, and show us trends over time.
It is important note that ratios often have no absolute significance and should be used to compare one company with another or compare one year to the next.
Profits and Profitability
There are two main measures of profitability covered here: “return on capital employed” (the profitability of the company pre-tax) and “return on shareholders’ funds” (how profitable the company is for its shareholders after tax)
Return on Capital Employed
Where the capital employed is the total amount of shareholders’ funds plus all the borrowings of the company.
Return on Ordinary Shareholders Funds
Profit Margins
We may want to look at net operating income or after-tax profit as a percentage of turnover in order to give us a margin expressed as a percentage.
Net operating income = profit before tax and finance charges (interest and leasing costs).
Or
So – the more profitable a company is, the faster it will grow, paying larger dividends along the way. This is also a way of seeing if a company’s funds are improving or deteriorating.
We know that the higher the risk, the higher the expected reward. So, the return expected on a share should be compared to the level of risk expected from the share. You can break this down further to fundamental risk and technical risk (the risk of bad/wrong timing – the more volatile, the greater the risk).
Fundamental risk can be quantified more easily from the financials.
Current Ratio
The current ratio looks at ratio of the company’s current assets to current liabilities.
This gives us an indication of how easily a company can meet its liabilities, such as creditors, overdrafts and loans, etc, payable within the next few months, from its current assets, such as the bank account, the sale of stock, debtors, etc
The current ratio is therefor a good indicator of how vulnerable the company is to insolvency.
Working Capital (or Net Current Assets)
Working capital is the money used in the day-to-day functioning of a company.
This shows the money ‘tied up’ in the day to day workings of the company, so most companies try to keep this to a minimum. The problem is finding the balance – since having too much work capital will result in a loss of profitability and having too little could result in running out of stock, losing to competitors as debtors move to better terms, or losing discounts with providers (creditors).
Interest Cover
Interest cover is the interest paid relative to net operating income:
Again, there is no preferred figure in isolation, but a level above 3 is normally considered normal. If this ratio falls below 3, in other words, where the net operating income is enough to cover the interest less than 3 times, then this is cause for concern. This is because interest on money borrowed ‘has’ to be paid on time irrespective of whether or not the company is profitable.
Debt-Equity Ratio
This ratio tells us where the company funding comes from – borrowings or equity.
There is no preferred figure with this ratio. It depends on both external and internal items such as the economy, the company’s profitability, interest rates and the impact of the economic cycle on the company. If the ratio is very high – it could mean that there is a risk in the company as it relied heavily on debt for funding. If the ratio is very low – it could mean the company is very conservative in its funding, or even inefficient, as it has little reliance on gearing.
Note: Gearing occurs when a company has debts to finance itself, which it will have to pay back. If the funding is successful and the company is profitable, the rate of return that shareholders get increases faster than if there was no gearing, and vice versa.
Debtors’ Collection Period
Debtors’ Collection Period is the numbers of days any turnover is tied up in debtors. If the figure is high, say 90 days, then the company is not collecting debts quickly enough – unless it is part of its offering. A lower figure, of 30 days, would imply that the company is very stringent at collecting its debts, but may run the risk of losing sales if it is not granting sufficient credit. .
Stock Turnover
The stock turnover is based on the cost of sales rather than the sales, unless the cost of sales figure is not available.
If the ratio is very high it may mean that stock is quite low relative to turnover. This may indicate that the company is running low or out of stock it could otherwise have sold at a profit. If the ratio is very low, on the other hand, it may mean that capital is tied up in stock that is sitting idle.
Growth and Profit Margins
Another management measure is looking at the relationship between the company’s profit margin and the company growth. This is more meaningful lif looked at as a progression over time. If turnover grows quickly, but profit margins shrink, then this is an indicator of problems in the future, such as gearing. If turnover grows slowly, but profit margins increase, then this is an indicator of more rapid increases in dividends in future. Generally, you want profits to rise at roughly the same rate as turnover over time.
Remember – when looking at ratios and other metrics, it is good to look at the trend over time, or to compare the company ratio to the ratio of a similar company or to the ratio of the sector in which the company operates. We are looking for consistency, conservatism and quality rather than numbers that are ‘all over the place’.
