Fundamental Analysis

This page is based on an article written by Roger Lawson and first published in the ShareSoc Informer newsletter in December 2011.

Previously I have talked about how to select good companies for an investment portfolio. Most of the discussion concentrated on qualitative aspects. This article attempts to cover some of the basic financial and other information that you should examine before you invest in a company (or monitor when it is in your portfolio). In other words, we are going to cover the “fundamental” financial aspects of a company as it is termed.

As with our warnings on the previous articles, this is a cursory overview of the science. There are lots of good books available on this subject – refer to the ShareSoc Recommended Reading List for some of them (for example, Graham & Dodd’s “Security Analysis”).  But as in any walk of life, a little knowledge goes a long way and there is a trade off between the length of time you spend on analysis and the additional information you gain.

The key is to screen companies by looking at some basic metrics, before examining the financials in more detail (where you think more review is required) and doing some more general background reading on the company—such as understanding the market in which it operates, the barriers to entry and other aspects. When you pick up a share tip, attend a company presentation, or discuss a company with friends, it’s always wise to do some basic financial analysis before investing in it.

Using Stock Screens

You can of course decide that you won’t rely on gossip newspaper articles, magazine tips, or rumours by using “stock screens” that go through the universe of available stocks and pick out those that meet certain criteria which you then investigate further. However the author has not found that technique a particularly productive one—it tends to select companies that are cheap for good reasons.

Terrible business models, major strategic challenges, those where the chief executive just quit, where the company has a legal threat against it, and numerous other problems will be revealed when you drill down into them. You can spend many hours wading through dross. But if you want to try this approach there are a number of web sites and software products that provide such screens—typically for a fee. For example, Investors Chronicle, the forthcoming Stockopedia Pro, DigitalLook, Company Refs, ShareScope, etc.

Some such screens are more flexible than others of course, with the advanced ones having more “criteria” you can use and enabling you to combine criteria in a number of ways.

Be Wary of the Data

Of course these screens are only useful if the underlying data which they are using is accurate and up-to-date. That is not always the case. Make sure you check recent announcements for changes in such parameters as shares in issue and the latest financial results.

Use a Simple Analysis Form or Spreadsheet

For many years I have used a simple form to analyse companies when I first review them (before I read the Annual Report and do more analysis). A blank version of a suitable form is now present on the ShareSoc Members Network (exclusive to ShareSoc full members), here. There is also a Spreadsheet on that Forum which automates some of the calculations and would enable you to save it in digital format. I retain these forms and sometimes look back at them to remind me why I invested in the company. Indeed even after I have sold an investment, sometimes many years later, I keep the form. Someday I’ll go back and analyse what factors influenced whether a company turned out to be a good or bad investment!

This form contains, on a single page, all the data I consider really important—others might disagree on that but I’ll try and explain why I think these are the important factors by explaining each of the fields in turn.

Why do I use such a form or spreadsheet and fill them out manually? Because until recently no information provider supplied all the data I wanted—and even those who now do so spread it over multiple pages or clutter it up with lots of trivial information so you are in danger of not seeing the wood for the trees. Below is a list of what the form contains.

Heading Summary

The top few lines of the form simply contain the basic information on the company such as name, EPIC/TIDM code, current share price, shares issued, market capitalisation and dealing spread. The dealing spread is the difference between the bid and offer prices (not an issue with most FTSE- 100 shares, but certainly worth noting if it is an AIM company).

Main Section

The middle part of the form gives the data for the last five years for sales, pre- tax profits, earnings per share and dividends, plus the forecasts for those for the next two years. This data is available from many free sources. I also include the last interims, and prior year interims, if those are available.

In summary, this data gives a good overall view of the trends in sales and profits, and whether they are consistently growing, or widely fluctuating. The profits and earnings are of course “unadjusted historic” figures while the forecasts tend to be “adjusted” ones so one has to be careful when interpreting this data for some companies.

At the foot of that table, I also show the historic and forecast price/earnings ratio (p/e) –  this is simply the earnings per share divided by the current share price. It therefore is a measure of how much you are paying for the profits that the company generates. Many investors use this as a simple “rule of thumb” to evaluate companies. Any figure below 10 might be considered cheap, although companies who are considered to be in difficulties, or have profits falling can be on a much lower ratio. Rapidly growing companies can be on higher ratios such as 15 or more. The average p/e on the FTSE All- Share at the time of writing is 9.1—but doom and gloom is prevalent of course.

Some analysts prefer to use an adjusted P/E called a PEG to reflect different growth rates but I have not personally found that useful. You could add that to the form of course if you find it helps.

Also in the centre table I show the net assets, assets per share and cash from the balance sheet. I don’t always bother to fill in the trends on those. Assets per share are of course usually a lot less than the share price. The other problem is that the net assets figure will often contain a lot of intangibles so it is very unlikely in most companies that you could wind up the company and realise anywhere near the net assets. Even ignoring that point, buying a company that looks cheap because the share price is less than the assets per share is a recipe for investing in dud businesses that are going downhill.

I show the cash figure also but that is not usually particularly relevant unless it is very high.

Financial Ratios

The bottom part of the form shows some of the commonly used financial ratios. These are:

• Price/sales. In other words the market cap divided by last year’s sales revenue, or what you are paying for the level of sales. Very high numbers indicate either that it is a technology company with wonderful intellectual property and prospects, or a low margin business like a retailer. It may be more relevant when comparing similar companies within a sector or looking at technology companies.
• Gearing. I now tend to show interest cover (the number of times interest payable is covered by pre-tax profits) rather than gearing—this is a good measure of whether the company can pay its bankers.
• Return on Capital. I show both the cash return on capital and accrued figure. The latter is simply the pre-tax profits divided by the net assets. The former is the “cash generated from operations” from the cash flow statement, divided by the net assets. I like to see a return on capital which is higher than 25% (which is not
  difficult to find). That is a key measure for how well the company is managed, and how well it uses the financial resources and other assets available to it—in my opinion. Look at it another way, not all of this return will come through to shareholders. Some will be re-invested in growing the business, some gets paid to other folks funding the business, so only some will come back to shareholders as dividends in the short term. But it’s still a good measure of the overall return you are obtaining. If the cash return on capital is less than the basic return, then I might look at the company more closely—it means profits are not being turned into cash for some reason.
• Current Ratio. The current ratio is the current assets divided by the current liabilities. For healthy trading companies it should be 1.3 or higher as it’s a good measure of
  “working capital”. Any lower figure tends to indicate cash flow difficulties (except in the case of retailers who tend to sell their goods before they have to pay their suppliers for them).
• Dividend Yield and Cover. This obviously shows what return you will get in dividends if you purchase the shares. The cover is the pre-tax profits divided by the dividends
  paid last year, a good measure of how “safe” the dividend is. Most companies prefer to have dividend cover of 2 or higher. The average dividend yield across all companies
  is currently 3.7%.

I hope I have shown how this kind of analysis enables you to get a good overview of the company—whether it is growing and its basic financial structure. I find it easier to use a simple form containing just that data than many data service providers who overload you with information.

Obviously this approach does not include any technical analysis factors such as share price momentum, measures of relative strength or comparison to other companies in the same sector—it solely looks at the fundamentals of the company.

For investment trusts and property companies you probably need to look at the discount of net asset value to share price but for investment trusts it might be more relevant to compare their performance against an index (Trustnet or the company’s web site will provide useful information on that subject).

Roger W Lawson