Fundamentals for the
Long Term Investor
So, maybe you're thinking of buying some shares, with the
intention of holding onto them for a while and seeing your investment grow. But
how long is a while? Could be anywhere between five and twenty years plus. If
you're a young and budding Warren Buffett, think decades. Mr. Buffett certainly
knows his fundamentals. They've helped make him a billionaire.
How do you choose the best company or companies to invest
your cash in? Perhaps you work for a publicly traded firm already, and you know
a bit about its track record. You have confidence in the CEO, and you know the
company is making a regular profit. So you're already doing fundamental
analysis, just armed with these two facts.
Fundamental analysis in the context of stocks is about
determining the true (or intrinsic) value of a stock. By looking at the
company's financials in detail, you might come up with a figure suggesting that
the stock price should actually be higher than the price its currently trading
for. This gives you an opportunity to buy at a discount. Of course we're
assuming here that your analysis is correct, but it isn't just figures you need
to consider. You also need to think about what the company does (do you
understand it?), how it fares against its competitors, the quality of the
management, the company brand, and its future direction. What kind of customers
do they have, and how many? These intangible factors feed into your decision
making, but aren't so easy to define and measure, and therefore less certain.
And the other assumption here is that the market will move
to reflect the true value that you believe the company to have. There is no way
of knowing this for certain either.
Having said all that, doing the work of analysis will definitely
contribute to the quality of your decision making. You can invest and hope, or
you can invest informedly. There's a lot
or research you can do online, for example, to understand the company you're
interested in from a purely intangible quality perspective. Company websites
should give you background on executives, what the company does, and maybe even
give you access to an Annual Report. You could attend an Annual Meeting if you
want to see senior management in action, and also get a feel for the mood of
the current shareholders.
Then there's the financial health of the company. The Annual
Report should include much of what you need to be looking at. Financial
statements included in that document are the Profit and Loss statement (or
Income Statement), the Balance Sheet, and the Cash Flow statement. Let's
briefly look at each of these in turn.
The Profit and Loss statement is telling you how much money
the company is generating, and more importantly, if it's making profit. So
we're talking about sales revenue, the expenses incurred in making those sales,
and the excess earned from that activity - i.e. profit. Basically, revenue -
expenses = profit, which should ideally be a positive figure. You want to look
at this over a period of years if possible, to establish that the company is in
fact regularly profitable, and that profit is growing. A standard Profit and
Loss statement will also give you last year's figures, so that's a helpful
starting point.
Then we have the Balance Sheet. This is a statement of the
assets and liabilities of a company. It's called a Balance Sheet because assets
and liabilities plus equity (or retained earnings) should always be equal.
Assets break down into current and non-current. Current assets consist of cash,
inventory, and accounts receivable. As a prospective investor you're looking
for a healthy cash balance which could be used to drive future growth.
Inventory is showing you how much money is tied up in unsold products. You
certainly don't want to see a proportionately large amount of money tied up
here. And finally, accounts receivable is showing you how much is owed to the
company. Current assets indicate the liquidity of a company, i.e. the amount of
cash it can quickly generate from the sales of these assets. Non-current assets
are things like property and equipment. These could be converted to cash, but
only over a longer time period, and as such don't merit your interest in the
same way current assets do.
Liabilities are the flipside of the equation, showing you what
the company owes. Current liabilities give you the short term debt situation.
So if current assets exceed current liabilities it's a good indicator of the
company's financial health.
Finally there's the cash flow statement. Although cash is
included in the current assets of the balance sheet, and also appears in the
profit and loss as part of revenue, it isn't telling you the whole story.
Without going into all the variables, the cash flow statement is telling you
just how much actual money is going through the company. A healthy amount of
cash available signals the ability of the company to meet its obligations, like
paying debts and dividends.
Having decided that your prospective investment looks
promising, how do you go about finding out if it's undervalued? This is where
financial ratios come in. There are many of these, and space limits their
discussion. They include discounted cash flow, earnings per share, cash return
on assets etc. For the sake of illustration we'll look at the price to earnings,
or P/E ratio. This give an indication of a company's share price against its
per share earnings, and reveals the company's expected earnings growth going forward. It's calculated by dividing the
market value per share by earnings per share. A high P/E means that investors
are looking forward to future higher growth.
Ratios are a complex subject and come with caveats. They
need to be used in combination and then evaluated as a whole picture. You can
get some idea of the validity of the P/E ratio for instance by comparing it
with those of companies in the same sector. Are they projected to grow earnings
at the same rate? And also remember that the ratio reflects the market's
expectations as opposed to the company itself.
If you want to know more about ratios and how they relate to
the valuing of a company you might like to check out 'The Intelligent
Investor', by Benjamin Graham. Graham was Warren Buffet's inspiration, and in
the foreword to the book he still thinks it's 'the best book about investing ever
written'.
The value investing approach may seem daunting and time
consuming, which is arguably true. But if you're serious about long term
investment, studying it in more detail could well repay your investment of time
as well as money.
Darren Winters
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