Taking a fundamental approach to investment is not easy. It requires quite a lot of investigative work, number crunching, and the application of careful judgment. For many young analysts the process can feel overwhelming and it’s hard to know where to start. After 10 years of doing fundamental analysis, I thought it would be useful to share some practical advice on the subject.
- What does the company do?
Before you start ask yourself the simple question “What does this company do?” You’d be surprised how many analysts find it hard to answer that simple question. It’s not enough to know what industry they operate in. You need to know exactly what role they fulfill. Who are they selling to and how do they generate their income? In most cases the company will have more than one product or service, so draw up a pie chart showing the split of revenues and profit for each line of business. You can get this information from the latest annual report on the website of the company.
- Get familiar with the company
Having established what the company does, you want to dig bit deeper. A good place to start is usually the “Management Discussion” from the latest annual report. Also on the investor relation page of the website you’ll be able to find webcasts of the latest results and the most recent investor day. These are all worth listening too for background information.
- What are the key drivers of the business?
As you conduct your research in step 2, you should be getting a good sense for the key drivers of the business. You can usually reduce any business to between 2-5 such key drivers. For example, a retail business will likely be driven by factors such as space growth, same-store-sales growth, and gross margin. An integrated oil company may be driven by the oil price, production growth and cost of exploration. Your sense for the key drivers will evolve as you carry out more analysis but it’s worth doing this exercise now as it will help you to focus on what’s important in the next steps.
- Analyze the past financials
“Study the past if you would divine the future” Confucius
Now take a look back at the last 10 years of financial statements to get a good sense of how the company performed over the past cycle. Gurufocus have an excellent free tool to allow you to do just this. Pay particular attention to revenue, gross margin, operating margin, ROIC and cash flow. For non-cyclical companies you are looking for stable or growing profitability over an entire cycle. For cyclical companies, you are looking to get a good sense for the range of revenue and operating margin. How high do margins go during a boom period and how low do they fall in a recession? Also look at how profitability has translated to cash flow historically. Anomalies should be investigated further by delving into historical annual reports, which are available on the company website. This will give you additional insights into the key drivers of the business and where the vulnerabilities lie. At this point it may also be worth drawing up a SWOT analysis (Strengths, Weaknesses, Opportunities, Threats).
- Study the Balance Sheet
Don’t forget to put some work in on the balance sheet. In particular look for any signs of over-leverage or liquidity issues. Look at ratios like debt/equity and interest coverage, as well as changes in the working capital. Also look at the debt maturity profile – a substantial amount of debt falling due in the next 12 months warrants special attention. Take a look at the videos on StockViews Campus in order to get a better understanding of how to read a balance sheet and how to calculate these key ratios.
- Qualitative Factors
Make sure you also have an understanding of the key qualitative factors. This includes, among other things, a judgment of the quality of management, company culture, processes and controls, products, R&D, and sales. Phil Fisher, the legendary growth investor, came up with a checklist of 15 points to consider. We have created a video on StockViews Campus running through each of these points in brief.
- Earnings Estimates
Now it’s time to use your understanding of the company to consider what the future holds. The amount of work you put in here is up for you – experienced analysts will want to create their own detailed models for the P&L statement over the next 2-5 years. For others it may be enough to have considered what management and consensus is expecting, and whether that is reasonable. In any case, consensus expectations are a good place to start. Yahoo Finance and CNN Money both have free tools that provide an estimate of where consensus for future years is. Estimize can also be useful, although focuses on quarterly rather than yearly estimates. You will probably rely on consensus estimates to begin with, but as you become more experienced you will naturally want to produce your own estimates (and you will find that Wall Street analysts tend to be systematically over-confident!). One word of warning here – don’t get too carried away with generating precise estimates. The key value of this exercise is in producing an approximate view of one version of the future. As events unfold you will want to update this view on a regular basis.
“Investing is all about value…what other kind of investing is there? Are we going to have nonvalue investing?” Warren Buffett
Ultimately everything comes down to value. Given everything you know about the company (quantitative and qualitative), what do you think it’s worth? And is that intrinsic worth higher than the price you would pay today in the market?
There are a number of methods you can use to determine valuation. In the first place look at multiples such as the P/E ratio, EV/EBITDA or P/FCF. Compare these ratios to the relevant peer group and to the stock’s own history. Both YCharts and my friends at Capp.io have great tools for helping you with this comparison.
As you become more experienced you will want to carry out full DCF (Discounted Cash Flow) valuations. There’s no need to be intimidated by these. Use the key-drivers you established in step 3 to build your model and don’t get sidetracked into calculating detailed estimates of immaterial items. The point is to create an approximate value based on one view of the future not to produce a precise forecast of every line. You can then subject your model to sensitivity analysis by flexing the key drivers.
Following the 8 steps above will ensure a disciplined and thorough approach to analyzing a company. Without this discipline, I often find young analysts will get carried away with one narrow aspect of the investment case, resulting in research that comes across as naïve. Forcing yourself to consider all the opportunities and risks in a balanced way will result in a far better outcome.