Category Archives: Fundamentals

The Structural Flaw in Data-Driven Quantitative Analysis

Rodin's ThinkerPeople who lean more towards fundamental analysis tend to think differently than others using alternate methods. There is a distinction between those people that rely on news and statements by management and fundamental analysts who rely solely on numerical analysis, which are probably more like technical analysts in their thought processes. Those who take a qualitative approach tend to question their assumptions more, because they rely on opinions and obviously everybody who engages in any kind of analysis should always question the underlying assumptions and learn the limitations of their systems.

I want to make it clear that I am not deriding technical analysis as a foolhardy approach. Even the most rigorous fundamental analysis is subject to the issues I discuss here. However, the severity and prevalence of the issues for fundamental analysis is lower. Technical analysis by its very nature exposes itself to the flaws of forecasting.

The Security Blanket of Numbers

Fundamental analysts using a numerical approach are not ultra-reliant on historical analysis to the extent that they limit exposure to assumptions regarding the future, however they share their faith in numbers with technical analysts. Rarely is the world so black and white, and often you might find yourself using a mixed approach. Something about the way we are wired makes us more comfortable trusting calculated numbers than the statements of individuals. I might not be exposed to a representative sample of people, but I see this worship of numbers far too often. It could be due to the fact that most people I know are science and engineering types. If you are surrounded by people more attuned to the philosophical theory of knowledge it might be different. Continue reading

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How Stock Fundamentals are Derived from Company Financials Part 3: Cash Flow Statement

File folderThis is the third and final installment of my series which looks at how company fundamentals are derived from the financial statements they’re based on. Previously we looked at the balance sheet and income statement, and in this article we’ll explore the often misunderstood cash flow statement. The cash flow statement ties the other financial statements together, in that it examines how the balance sheet changes, based on income and cash flow into or out of the company, and is a good measure of the company’s liquidity. Continue reading

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How to Calculate WACC

help iconWeighted Average Cost of Capital (WACC) is defined as the minimum return that a company must generate to satisfy its owners, creditors, and other providers of capital or else it would make more sense for them to invest elsewhere. Since there are different components that make up a company’s overall capital, each possibly with a different cost associated with them, this method blends them into an overall cost, proportionally weighting each component based on its size.

Let’s look at a simple analogy first. Suppose we are interested in determining how much a bag of mixed nuts cost. Peanuts make up 60% of the bag and cost $1.99 / lb. Almonds are just 20% of the mix but cost $3.99 / lb. The final 20% of the bag is Macadamia nuts at a cost of $5.99 / lb. How much does 1 pound of mixed nuts cost? We have all the information we need to answer this question. We know the relative percent, or weight, carried by each component and we also have a cost for that component. Continue reading

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How Stock Fundamentals are Derived from Company Financials Part 2: Income Statement

File folderIn the first installment of this series, we looked at a company’s balance sheet to learn how to derive a number of useful fundamental ratios and metrics about the company. Since balance sheets are based on a reconciliation of the company’s assets and liabilities, the fundamentals that arise from this information give us a good idea of the company’s financial health. In part 2 of this series, we will examine the income statement, and determine how additional metrics such as the PE, PEG, market capitalization, and ROE are determined, among others.

This time around we’ll use the most recent annual report from Apple (AAPL) to go by, and we’ll use GuruFocus to compare our calculations with an online source. I use GuruFocus because it provides access to the past 10 years of financial data and supports nearly all of the ratios and metrics we’re interested in.

See also: Part I of this series: Balance Sheets

Apple’s fiscal year 2012 annual report was issued on October 31, 2012 and was based on the 12 months ended September 29. I would suggest that you download a copy of it so that you can follow along. The income statement can be found on page 43, and is called the Statement of Operations in this case. There will be a few situations where we need to pull some information from the other statements, but all of these are readily available in the same report. The following screenshot shows Apple’s 3rd quarter 2012 income statement (click to enlarge).

Apple 2012 Income Statement

As mentioned above, we’ll be using GuruFocus’ numbers as a comparison to the ones we derive ourselves. A link to Apple’s fundamental data on GuruFocus can be found here.

Market Capitalization

The size of a company is often measured by what’s called its Market Capitalization, which is a number which represents what it would cost to buy all of the company’s common stock right now at its current trading price. It is calculated by multiplying the total number of common shares outstanding by the current price per share as follows: Continue reading

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How Stock Fundamentals are Derived from Company Financials Part 1: Balance Sheet

File folderValue investors are very interested in the fundamentals of the companies they invest in, particularly historical data over the past 5 – 10 years. These days it’s easy to go to any of dozens of websites and pull up fundamental data such as EPS, P/E Ratios, Debt/Equity Ratios, and virtually any other metric you can think of simply by entering a ticker symbol. But where does this data ultimately come from?

The answer is that it comes from the company financials which are reported annually and quarterly in the form of a balance sheet, income statement, and cashflow statement. Why do we care? Well there’s two problems that the company financials can help us solve. First, most of the websites that provide this pre-calculated fundamental data, only do so for the current year. If we want to know what the debt/equity ratio was 8 years ago for example, we need to look at the company financials. That brings up the second problem. If you look at the financials, you won’t find the same metrics we’re used to seeing. Most of the fundamentals we’re used to seeing are actually derived from various line items on the financial statements, and to a non-accountant it’s not always immediately obvious which ones to use!

This post is the first of a three-part series, in which we’ll look at company financial statements line by line and derive the fundamentals we’re used to and love. Today we’ll look at the Balance Sheet. Continue reading

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How to estimate future PE ratios

Much the same as future EPS growth, estimation of future PE ratios is an important skill to have in place as a value investor. A company’s price to earnings ratio (PE) is a relative measure of how expensive or cheap a company is – check out this primer explaining what factors affect PE and why it’s important. In this article we’ll look at a few different techniques to estimate future PE ratios. Continue reading

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How to estimate future EPS growth rates

One of the most important factors that affects a company’s share price is the expected growth rate of the EPS (earnings per share). It logically follows then, that value investors would factor this important piece of information into the determination of a company’s intrinsic value. For most valuation techniques, the future EPS growth rate is the most important and influential factor in arriving at an accurate valuation. Fortunately, there are a few simple methods we can use to determine how to estimate the future EPS growth rate. Let’s see how. Continue reading

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What is the difference between Price and Value?

One of the most important concepts to grasp as a value investor is one that is perhaps not that intuitive to everyone. That concept is that the price of a stock and the value of a stock are two different things, and they are not necessarily equal – in fact they almost never are!

This is important, because value investors are interested in buying companies when the price is less than it’s true value. In other words we are bargain hunters, and seek to buy at the lowest price possible. But what exactly do we mean when we say that price is not the same as value? When IBM is trading at $60 per share, doesn’t that mean that it’s worth $60? The answer is no – let’s see why. Continue reading

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How to use PE ratios for stock evaluation

In a previous article, we explored earnings, why they’re important to us as investors, and learned how to calculate EPS (earnings per share). In summary, EPS is simply a way to express a company’s earnings in a manner that is independent of the number of shares outstanding. This allows us to do some pretty useful comparisons between companies, especially when we introduce the PE ratio (Price / Earnings ratio).

We’re going to look at how we can use PE ratios to determine whether a stock is expensive, cheap, or priced comparatively to its peers. But first, let’s look at how businesses are priced in a bit more detail. To do this, let’s look at a fictitious company, XYZ which had earnings (profit) of $10,000 last year. Let’s ignore the value of the company’s assets for a moment and assume they’re zero. How much is XYZ worth? Continue reading

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What is EPS (earnings per share)?

A company’s earnings are the reason for its existence, and is defined as the revenue minus the cost of sales, operating expenses, and taxes. In simpler terms it’s how much profit the company made. As value investors, we are very concerned about a company’s earnings (or lack thereof) as earnings figure greatly in determining a company’s value. It only makes sense that a company with a very high probability of increasing it’s profit year after year is more valuable than one in which earnings growth is stagnant or even declining. Companies generally report their earnings quarterly, and it’s not uncommon to see share prices rising or falling rapidly after the announcement, particularly if the result was unexpected.

Why do we care about earnings?

Or more specifically, why do we care about earnings growth? As investors we typically want to see the companies we invest in grow. To effectively accomplish that goal money is required, so companies with earnings that grow higher every year have more money to invest in their growth. This could take the form of the purchase of new factories, hiring of new employees, expansion into new markets, or additional research & development of new products to name a few. Companies can also take on debt to finance growth, however at some point debt becomes so high that this is no longer practical, and earnings are still required in the future in order to pay off the debt.

We therefore care about earnings because it’s a great indicator of future company growth – and growth often means an increase in share price. If the company’s management feels that they cannot invest earnings in a way that will produce adequate returns, the company may opt to commence or increase dividend payments to shareholders. In both cases earnings are a good thing for investors, as it ultimately means an increase to our bottom line.

Size matters

Company size that is. Let’s say that company XYZ earned $1,000,000 last year. Is that a lot? Could they have done better? Sure, a million dollars may sound like a lot to you and me, but it means nothing without knowing the size of the company. A company that’s worth $5 million would be doing very well to earn $1 million per year. However a company worth $5 billion wouldn’t be doing so hot. The size of companies is measured by what’s called it’s market capitalization, and is calculated as follows:

Market cap = (Price per share) x (# shares outstanding)

Let’s look at Microsoft for example. As of today’s writing, Microsoft was trading at $27.68 per share. Microsoft currently has 8.42 billion shares outstanding. We multiply these two numbers together to arrive at a market capitalization (market cap for short) of $233 billion! In other words, this is the amount it would cost if you could convince every other shareholder of the company to sell you their shares at the current market price of $27.68.

How to calculate EPS

Let’s take it a step further now and look at earnings. Just as share price is meaningless when determining the market cap of a company until the number of shares are figured in, the same holds true for earnings. It is much more useful to look at earnings on a per share basis, so that there’s an equal playing field when comparing earnings of different companies. Earnings per share is usually abbreviated to EPS and is calculated as follows:

EPS = (Net Earnings) / (# shares outstanding)

Let’s again look at Microsoft. Last year (2012) Microsoft had net earnings of $16.98 billion. If we divide that by the same 8.42 billion shares outstanding that we used above, we arrive at an EPS of $2.02. This is a much more useful number that earnings on its own. Now we have a basis that we can use to compare with other companies, and we can calculate other useful metrics such as the PE ratio (Price / Earnings ratio).

Where to find EPS data

To calculate EPS, the only information we need is the company’s earnings and number of shares outstanding. This information is readily available within every company’s income statement, and is also summarized in a number of online stock market research websites that are available for free. Let’s look at an income statement first. Following is Microsoft’s income statement for 2012, included in their annual report. It can be found here.

msft_income_statement-2012

The income statement contains all of the information we need to calculate EPS…. actually we don’t even need to – they calculate EPS for us! Earnings in this case is referred to as net income and is listed on the income statement as $16,978 million. It’s usual for income statements to list all numbers in millions for consistency. The number of shares outstanding is listed under Weighted average shares outstanding. Note that there’s two numbers here, a Basic and a Diluted. We’ll get into the difference between these below. Using the basic shares results in an EPS of $2.02 as we calculated previously, and using the diluted number results in a slightly lower EPS of $2.00. Note that both of these EPS values are calculated for us on the income statement itself under Earnings per share.

There has to be a more efficient way of obtaining these values than sifting through annual reports. There is. There’s a whole host of websites that gather and summarize this information for you. Let’s look at one of my favorites – msn Money. The msn Money website can be found at http://money.msn.com. Let’s go there now and pull up the information on Microsoft stock by entering the stock ticker MSFT.

msft-msn financial highlights 2012

Out pops the income, shares outstanding, and even a calculated EPS number just as we wanted, all contained a little down the page under the Financial Highlights section. But wait – the EPS shown here is only $1.85! Why is it different? Notice the asterisk (*) beside the income value of 15.71 billion, and the note at the bottom “last 12 months”. The income numbers in the annual report were as of the fiscal year end 2012. The information on the msn money website however is as of the most recent quarterly report. This is sometimes referred to as the trailing twelve months and abbreviated to ttm. It’s the most current information available, but it’s important that you realize where the data comes from. Annual data is also available on msn money, just in a different area:

  1. Go to msn Money and enter in the stock ticker (MSFT in this case)
  2. Click on 10-Year Summary found in the menu in the left hand column
  3. Earnings and EPS for each of the last 10 years are listed under Total net income
  4. Shares outstanding for each of the last 10 years is listed under Shares outstanding

Here’s a screen shot:

msft - msn 10 yr summary 2012

What’s the difference between Basic and Diluted EPS?

We saw above that the income statement listed two numbers for shares outstanding. There was a number for both Basic, and a slightly higher number for Diluted. These translated into two separate values for EPS – again both a Basic and a Diluted dollar amount. What is the difference between these two?

The basic number of shares outstanding is essentially the true number. There is physically this number of shares in existence at this moment. The diluted number takes into account other investment vehicles which could become additional shares at some point in the future – most notably stock options, warrants, and convertible bonds – if all of these were to be exercised. In this respect, the diluted EPS value is really a worst case scenario number of shares. Assuming that the earnings stays the same, the worst case EPS would be based on using the diluted number of shares outstanding. For conservative calculations, the diluted EPS is therefore most commonly used.

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