1. Fundamental analysis – Part I
Chapter 12

2. Overview of fundamental analysis
Fundamental analysis attempts to use publicly available information to evaluate securities in an attempt to measure the security’s intrinsic value.
Fundamental analysts (sometimes called value investors) try to answer the question:
“What is this security actually worth?”

3. Five factors for fundamental analysis
Overall economic conditions – These include factors such as the overall economic environment of the countries or regions important to the security.
The firm’s financial performance – How does the firm make money. In addition, they want to understand how profitable a firm is and establish criteria to estimate the company’s growth prospects.
The firm’s financial position – Does the firm have sufficient resources to protect itself in a downturn and to invest in itself for the future.
The firm’s management – Fundamental analysts will make efforts to ensure that a firm’s management is experienced, stable, and honest.
Valuation – Adding complexity to the investing decision is the fact that there is a difference between a good company and a good stock. Valuing a firm is important to ensure that the analyst doesn’t pay too much for the security.

4. (1) Overall economic conditions
The macro-economy – How is the overall economy doing?
The business cycle –In what stage of the business cycle is the economy in? Is the economy growing or retracting – at a top or near the bottom?
Industry analysis – What is the economic data suggesting about the future prospects of different industries/sectors?

5. (2,3) Assessing the firm
The Securities and Exchange Commission provides updated and historical filings for every publicly-traded company on its EDGAR database found on the SEC’s website (sec.gov).
10-Q Report: quarterly statements of financial condition to SEC.
10-K Report: Annual statement of financial condition.

6. 10-K Information Elements
Management discussion and analysis (MD&A) –Look at the firm’s performance from management’s perspective.
Risk factors – Lists every actual and potential risk that they see in the market.
Changes in and disagreements with accountants on accounting and financial disclosure –
Footnotes – contains detailed descriptions of items in the report.
Auditor’s Opinions – external auditors required by law for public companies. Some red flags; use of term “going- concern” to describe company. Recent change in auditor may be a flag.

7. The Annual Report V-V 10-K
Companies Annual Report to Stockholders v-v 10-K Report to SEC.
The firm’s annual report is an annual publication provided to shareholders that describes the year’s operations and financial performance.
Will contain much of the same information provided in the 10-K, but with significantly more “marketing” material. Usually available on firm’s website.

8. (4) Assessing management
The proxy statement is a document provided to shareholders that describes issues to be voted upon at the next shareholder’s meeting. In addition, the proxy provides tremendous insight into a firm’s management and board of directors.
Proxy statement topics
Management’s experience: There are detailed biographies and resumes for the management team of the firm on the proxy statement.
The board of directors: who are they and what other companies are they active in? This is quite common. Most important: are the neutral?
Compensation: How are the senior managers of the company paid? Salary and bonus metrics, stock options.

9. (4) Assessing management (cont.)
Conflicts of interest: If someone on the board has a conflict of interest (perhaps another business relationship with the firm), then this is disclosed in the proxy.
Ownership details: Do executives own significant numbers of shares of the company stock? If so, then it means that their interests should be aligned with your (shareholder) interests.
Views of other investors: If you view the proxy, you can see if any of these shareholder proposals are worrisome to you as a potential stockholder.

10. (5) Firm valuation
To decrease your chances of overpaying for a stock, you can use several different valuation methods to actually develop a price target based on the company’s performance and prospects.
The absolute method – This method of valuation attempts to find the intrinsic value of the firm based on its fundamentals
The relative method –The relative method determines a firm’s valuation by comparing the firm to other similar firms.

11. Top-down fundamental analysis
We will be using the “top-down” approach to fundamental analysis. Only after the economy has been assessed, does the top-down investor begin to explore specific firms.
The macro-economy
Macro Indicators
Gross Domestic Product: The market value of goods and services produced domestically in each time-period
Unemployment Rate: The ratio of number of people classified as unemployed to the total labor force
Inflation: The rate of change in the general price level as measured by some price index: Consumer Price Index, Producer Price Index, GDP Deflator

12. Top-down fundamental analysis
Other Macro Indicators
Budget Deficits: The budget deficit is the amount by which government spending exceeds government revenues.
Interest Rates: Major impact on security prices (stocks and bonds) and the level of economic growth
Business Cycle: business activity over time tends to resemble a sine-wave. Troughs followed by period of expansion in economic activity. Economy will peak at some point and begin a decline to a trough (or bottom of cycle).

13. Business Cycles
Economic activity tends to change in relatively predictable patterns, known as the business cycle.
GDP output at different stages of the business cycle

14. Business Cycles
Cyclical sectors tend to be extremely sensitive to business cycle changes.
Defensive sectors are much less sensitive to changes in the business cycle.
Sector rotation describes the re-allocation of assets based on the stage of the business cycle. Moving invested capital from cyclical to defensive issues as the cycle progresses.

15. Possible sector rotation strategies for the stages of the business cycle

16. Analyzing financial statements
No fundamental analysis is complete without a thorough review of the firm’s financial statements. The goals of Generally Accepted Account Principles (GAAP) are to make financial accounting “relevant, reliable, and useful”.

17. Income statement
The income statement provides you with insight into just how well the company is doing.
Revenue – Cost of goods sold – Operating expenses + Other income – Other expenses – Interest expense – Taxes = Net income
Also contains earnings per share (EPS) calculations
EPS = Net Income / Number of Shares Issued and Outstanding
Diluted EPS = NI / Outstanding Shares plus Executive Stock Options
I/S also includes Extraordinary Items and charges for Discontinued Operations.

18. Balance sheet
The balance sheet shows what the company owns (assets), what it owes (liabilities) and its [net] Equity in the business.
Assets – items the company owns
Liabilities – items the company owes
Stockholder’s equity – value left over after subtracting liabilities from assets
Equity Capital defined as moneys invested in the business over time; i.e., Stock, Retained earnings (portion of profits reinvested in the business).
Assets = Liabilities + Equity

19. Statement of Cash Flows
The cash flow statement tracks and reports a firm’s cash inflows and outflows only. Where did the cash come from and how was it used? Explains changes in the cash balance from last year to this year.
The statement tracks a firm’s cash by breaking up the firm’s cash flow into three separate categories:
Operating activities – cash generated or reduced from a company’s core business activity
Investing activities – cash generated or reduced as the company upgrades and re-invests money back into the business
Financing activities – cash generated or reduced from transactions with lenders and/or investors

20. Analytical Methods
For the numbers to provide you with insight you need to compare a company’s most recent period’s results with:
Historical Trends; are sales increasing? Does firm generate more profit per dollar of sales? (like athlete’s personal best stats.)
Compared to industry; how do the operating metrics compare to other companies in the industry? Are we growing faster? More profitable?

21. Analytical Methods
3. Profitability: What portion of sales dollars does the firm keep after each level of expenses
Gross Profit = Sales minus Cost of Goods Sold
Gross Profit Margin = Gross Profit / Sales
Operating Profit = Gross Profit minus Selling, General & Administrative Costs
Operating Profit Margin = Operating Profit / Sales
Net Profit = Operating Profit minus Depreciation, Interest and Tax Expenses (the ultimate “bottom line”)
Net Profit Margin = Net Profit / Sales

22. Working Capital
Working Capital is defined simply as the difference between the firm’s investment in Current assets and how it finances them with short-term liabilities.
The important ratio is the Current Ratio = Current Assets / Current Liabilities.
The magnitude of the Current Ratio is determined by several factors. The most important being the volatility of sales activity. If sales are volatile, then the firm is most likely to carry a high current ratio (greater than 3 or 4 times). If on the other hand, sales are relatively stable over time, the firm may carry a lower current ratio (less than 2).

23. Working Capital Management
Working Capital Management examines how the business manages the magnitude of the Current Ratio over time.
Conservative WCM: The firm finances a relatively small portion of its current asset investment using current liabilities (Accounts Payable, Notes Payable, Accrued Expenses). In effect, current asset investment is financed with long-term debt and equity. The current ratio is greater than 3 or 4 times: $3 or $4 in current assets for each $1 in current liabilities.
Moderate WCM: The firm finances about half of its current assets with current liabilities. The Current Ratio is approximately 2 times.
Aggressive WCM: The firm finances most of its current assets with current liabilities. The Current Ratio is approximately 1 time..

24. Monitoring cash flow (earnings quality)
As an investor, you want to know that the firm’s earnings are due to increased sales and lower costs.
If total cash flow from operating activities ≥ net income, then the firm’s earnings are high quality.
If total cash flow from operating activities < net income, then the firm’s earnings are low quality.

25. Monitoring cash flow (earnings quality)
Free Cash Flow
A company’s free cash flow is basically the amount of cash that the firm produces in its normal course of doing business. However, free cash flow can be negative. Rather than produce cash, some companies exhaust it!
Free cash flow = cash flow from operating activities – capital expenditures
If free cash flow is negative
If you have determined that a firm is utilizing more cash than it is generating, then you can perform a quick calculation to help you determine how long the company has before it depletes its cash reserves (its survival period).

26. If free cash flow is negative
If you have determined that a firm is utilizing more cash than it is generating, then you can perform a quick calculation to help you determine how long the company has before it depletes its cash reserves (its survival period).
Survival period = Liquid assets / (Free cash flow)

27. Homework Assignment
Key Terms (what do they mean or what information do they contain): 10-K, 10-Q, Balance Sheet, Income Statement, Statement of Cash Flows, Dilution, Earnings per share, Free Cash Flow, Gross/Operating/Net Profit Margins, working capital, working capital management
True or False: 5, 7, 8, 10, 11, 12, 13
Fill in the Blank: 1, 3, 5, 7, 8