The Complete Guide for Fundamental Analysis: Only 3 Easy Steps
Want to know how to perform a fundamental analysis? Great, then this is the place to be! Because here I’m going to show you the simplest guide to do a complete fundamental analysis.
Maybe you have already read my article on the simple, 5 step framework for financial analysis? Well, this is where I introduce an in-depth but still easy framework for company and stock analysis. Perfect for all value investors.
Specifically, we are looking at the very first layer of the framework for financial analysis. This is fundamental analysis.
In fact, there are only 3 simple steps you have to complete do get the fundamental analysis done:
Analyzing a company’s financial health and stability
Analyzing a company’s profitability
Analyzing a company’s growth
Analyzing a Company’s Financial Health and Stability
Let’s take a look at the first step of the complete guide for fundamental analysis: analyzing a company’s financial health and stability.
At the very beginning, we have to check whether the company has a solid financial foundation. Only with a rock-solid foundation it makes sense to take a deeper look at the company.
In particular, we are interested in the company’s financial leverage: the amount of debt in relation to the company’s equity. Overall, financial leverage has quite some power, positively as well as negatively.
On the one hand, debt leads to interest payments, which reduce the company’s taxable income, and subsequently increase its profits. Thus, a so-called tax shield is created that benefits the company.
On the other hand, especially in bad times with lower revenues, debt increases a company’s earnings volatility. This is because the same tax rate is deducted from lower levels of gross profit and thus, reduces net income.
Example table of P&L (good vs. bad year)??
To analyze a company’s financial health, we are looking at three financial ratios. They help us to evaluate the company’s dependency on debt and its liquidity.
Debt/equity (D/E) ratio
A company’s amount of debt in relation to its amount of equity tells you something about its financial leverage. Financial leverage simply describes how much dollar of debt a company has per dollar of equity.
You know that there are positive and negative sides to financial leverage. In addition, you should always take the different points in time into consideration.
For example, high leverage might not be as critical in very good and prosperous times compared to crisis times. Also, financial leverage – as every other financial ratio as well – should always be looked at in a broader industry context. High financial leverage might be more common in some industries compared to others. Respectively, that might be highly capital intensive such as manufacturing and less capital intensive such as professional services. If you want to know more about the advantages and disadvantages about debt or equity financing, applicable for startups as well as mature companies, see this article.
Overall, there is no perfect debt/equity ratio a company should strive for. There is no black and white. However, be aware that a value < 1 indicates that the company has more equity than debt. It could possibly pay back all its debt at once with its equity. Thus, make sure the debt/equity ratio is always decently below one.
The current ratio is a liquidity metric. It tells you how much money a company has available on short notice. Specifically, it tells us how much money would be left if the company had to repay all of its current debt at once.
Usually, “current” is defined as less than 12 months. Thus, a company must be able to sell its current assets within less than 12 months. Also, it’s current liabilities are due within 12 months.
Generally, a current ratio >1.5 is seen as solid. If you want to be even more conservative, >2 is a good proxy for you.
The quick ratio is only slightly different to the current ratio. It is especially relevant for highly capital-intensive companies, such as retailers or manufactures. That’s because we are taking out inventories. Some of them might not be as liquid as they should be in an emergency. Further, they might have lost in value since they were bought.
Ending up with a current ratio > 1, gives you quite a good foundation.
Once you are done with the first step, let’s complete the second step of the complete guide for fundamental analysis…
By now you know the company has a solid financial foundation. However, this is only the first step performing a fundamental analysis. On this foundation, the remaining layers build up and lead you to the results of a complete company analysis.
Thus, the second step when following the complete guide for fundamental analysis is looking at the company’s profitability. Here, the winning formula is quite simple: successful companies take money from outside investors and invest it within the company at the greatest possible return. Ideally, investors will be paid out sufficiently and the company generates enough money to put something aside.
If and only if a company is generating a decent return relative to the money invested into the business, it makes sense to go one step ahead in our framework. To see whether this is the case, we look at four financial key performance indicators (KPIs) in particular:
Return on assets (ROA)
ROA is a measure of efficiency. It looks at how much the company is earning in relation to its total assets. In other words, it looks at how well a company is making use of its assets.
As you can see, there are two financial variables that impact the equation: net income and total assets. Thus, both can be drivers for the level of ROA. Either, a company can have high net income, which is driven by high margins or large revenues, such as service companies. Or, a company can have a high asset turnover, i.e. assets are sold very quickly, such as retailing companies.
Overall, the higher ROA, the better. Regardless of the company type.
Return on equity (ROE)
Similar to ROA, ROE is also a measure of efficiency. It looks at how well a company is making use of its shareholders’ equity in relation to net income.
This time, however, there is another dimension in the equation: financial leverage. Shareholders’ equity is calculated as total assets minus total debt. Thus, the level of shareholders’ equity largely depends on the level of total assets and debt. As we have learned in step #1 of the framework for financial analysis, the relation of total assets to debt is simply financial leverage.
Therefore, a company’s ROE largely depends on its financial leverage. Since we have considered this ratio already in step 1 of the analysis, you should have clarity on that by now. So if the company has a consistent ROE above 10 it is usually seen as to be quite solid.
Are you wondering if a company can also have a negative ROE? Yes, it can. Of course, in that case you might rather not invest into that company in the first place. However, if you want to know if negative ROE always means the company is a bad investment, see this article dedicated to this topic
Free cash flow (FCF)
In classical accounting, there are many ways of calculating FCF. Yet, you probably do not want to become an accountant and dig into nerdy formulas. Rather, you want to learn how to properly use and interpret financial ratios.
For now, we make use of a company’s cash flow statement. In particular, we take the cash flow from operating activities and deduct capital expenditures. Capital expenditures is the amount of money a company uses to make internal investments. For example, to renew machinery, invest into buildings, buy equipment, or other assets required to do business.
Generally, if a company is able to convert more than 5% of its revenues into FCF, it’s said to have a solid footing and generating excess cash. For that, you simply take total the FCF and divide it by total revenues.
For example, let’s look at BMW. heir FCF from automotive sales in 2017 was 4,459 m€. Also, their revenues from automotive sales in 2017 were 88,581 m€. Dividing the FCF by the total revenues, you get 5%. Thus, we can infer that BMW had a sufficiently high FCF in 2017.
Return on invested capital (ROIC)
A more advanced formula for calculating a firm’s efficiency is ROIC. That’s because it completely removes the debt portion that makes high debt companies look more profitable.
First, a different form of profit, namely net operating profit after taxes (NOPAT), is used. This is before taxes, making a company’s profit more comparable and independent of tax payments. Second, the formula only uses invested capital, not total assets or equity. Thus, any debt that might inflate the balance sheet totals is not considered.
Again, a higher ROIC is always better than a lower one. Use similar thresholds as for ROE and ROE, so a value constantly > 10 is quite good.
Now, let’s complete the next step in our guide for fundamental analysis…
Steps 1 and 2 are done and we are approaching the next level of our fundamental analysis. We know that the company is overall in a good shape and profitable. Going back to our simple financial analysis framework, it tells us the next steps to do.
You have to look at growth! Besides financial stability, growth is important, too. It can by manifold: revenue growth, earnings growth, employee growth, growth in number of products sold, etc. Further, it can be achieved through different methods:
- Sell more, i.e. a higher quantity of your products
- Make you products/ services more expensive, i.e. sell more expensive
- Sell new products
- Pursue M&A (mergers & acquisitions) activities, i.e. buy another company or merge with one
Of course, all the just mentioned activities will eventually impact overall growth. But we are specifically interested in two things: revenues and net income. They have the most crucial impact on the other KPIs we are analyzing. That’s why they are used at this stage.
Overall, revenues should be decently high and growing. Of course, since we are only analyzing listed companies, size should not be a problem. Still, you want to make sure that the company you might want to invest in is prospering.
Revenues are the most honest indicator for growth. That’s because they are the very first line item in a company’s income statement. Thus, their level cannot artificially be inflated. When looking at a company simply make sure revenues are growing in the long-term.
Similar to net income, it should also be growing. Since investors participate in a company’s earnings strenght, net income and profitability are very important. Always make sure that net income is growing in the long-term.
However, be aware of two things. First, keep in mind that net income might be highly distorted. Since there are many accounting tricks and treatments that a company can legally apply, net income might not fully or less realistically reflect the company’s state. Second, keep the profit margin (net income divided by revenues in mind). If net income is growing faster than revenues for more than 5 to 10 years, you should be cautious and do some further research why this has been the case.
Final Thoughts on Fundamental Analysis
Now it’s up to you! By now, you have the complete guide for fundamental analysis. I told you the most important financial ratios to consider. However, they are very simple and straightforward at the same time.
Which company are you going to analyze first?
Will you maybe even add another financial ratio to your analysis?
Either way, let me know by leaving a comment below right now.
Btw, this is how you should proceed after the fundamental analysis: click here and learn how to analyze a stock. (>>link to aritkel)
Thanks for reading this article. Please, let us know if you have feedback, corrections, or any further question (either down below in the comments or via contact). We are happy to discuss and further support you along your way to becoming a “yield reviewer”
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