Most traders don’t worry about the fundamentals. These numbers include the general economic and market conditions that impact a stock (see Chapter 5 for an overview of these), as well as the financial information known about a company’s activities and its financial successes and failures. Instead, traders tend to focus entirely on technical analysis and trends that can be seen using that type of analysis.
Taking the time to analyze the fundamentals of a stock puts you one step ahead of the trading crowd. Using fundamental analysis, you can determine how a stock’s price compares with those of similar companies based on earnings growth and other key factors, including business conditions. This chapter helps you understand critical parts of fundamental analysis and how you can use the information gathered from it to make better trading decisions.
When starting a fundamental analysis, select an industry or business sector that interests you for possible stock purchases. Sometimes a particular company piques your interest, and you start your research by looking at the major players in that company’s sector or by turning to the sector’s fundamentals. Regardless of how you start, you need to narrow down your list of the companies you want to compare to the ones that are in similar businesses within the sector so you can find the best opportunity. You also want to be sure the stock trades well by looking at its daily volume of trades. Stocks with low trading volume can be hard to get into and out of, making them riskier stocks.
Most of the tools used in fundamental analysis require you to compare at least two companies operating in similar business environments to understand the meaning of the information. For the purposes of discussion in this chapter, we look at two big players in the home‐improvement retail sector: Home Depot and Lowe’s. If you’ve followed the business conditions in this sector, you know that both faced a severe downturn after the housing bubble burst in 2007. Housing still hasn’t fully recovered, and Home Depot didn’t build any new stores in 2016. The expansion of Lowe’s has primarily been in Canada with the purchase of Canada’s RONA.
Before discovering the tools of fundamental analysis, you first must understand how to read key financial statements, including the critical parts of the income statement, cash‐flow statements, and the balance sheet.
Checking Out the Income Statement
The income statement is where a company periodically reports its revenues, costs, and net earnings. It’s basically a snapshot of how much a company is earning from its operations and any extraordinary earnings that may have impacted its bottom line during a specific period of time. From the income statement, you can determine the impact of taxes, interest, and depreciation on a company’s earnings and forecast earnings potential.
Every income statement has three key sections: revenue, expenses, and income. The revenue section includes all money taken into the company by selling its products or services minus any costs directly related to the sale of those products or services (called cost of goods sold). The expenses section includes all operating expenses for the company not directly related to sales, as well as expenses for depreciation (writing off the use of equipment and buildings — tangible assets), amortization (writing off the use of patents, copyrights, and other intellectual property or intangible assets), taxes, and interest.
The income section includes various calculations of income. Usually you find one calculation that shows earnings after operating expenses and before interest, taxes, depreciation, and amortization called EBITDA. This is followed by net income, which is the bottom line showing how much a company earned after all its costs and expenses have been deducted. Public companies must file financial reports with the Securities and Exchange Commission (SEC) on a quarterly and annual basis.
You can read any public company’s financial reports at the Edgar website (www.sec.gov/edgar.shtml).
A year’s worth of figures doesn’t show you much, so you need to look at the trends throughout a number of years to be able to forecast growth potential or assess how well a company is doing compared with its competitors. We discuss a number of good sources for finding fundamental information in Chapter 4.
Both quarterly and annual reports are important. Comparing a company’s results on a quarter‐to‐quarter basis gives you an idea of how well the company is meeting analysts’ expectations and its own projections. For example, looking at results for the first quarter of 2017 versus the first quarter of 2016, you can see whether a company’s earnings are increasing or decreasing in a similar market environment. While for some types of companies the first quarter is generally productive, other types of companies, such as retail stores, depend mostly on fourth‐quarter holiday results, so you need to know what’s expected in earnings for the various quarters.
While quarterly results allow you to monitor results from similar time periods, annual statements give you a summary for the year. You can also compare current‐year results to the results over a number of years to see at what rate the company is growing.
Revenues
The first line of any income statement includes the company’s sales revenues. This number reflects all the sales that the company generated before any costs are subtracted. Rather than go to all the trouble of showing their math most companies show only net sales on their income statements. From these figures, you want to see obvious signs of steady growth in revenues. A decrease in revenues from year to year is a red flag that indicates problems and that it’s probably not a good potential trading choice.
Cost of goods sold
The cost of goods sold (also known as cost of merchandise sold or cost of services sold, depending on the type of business) is an amount that shows the total costs directly related to selling a company’s products or services. The costs included in this part of the revenue section include purchases, purchase discounts, and freight charges or other costs directly related to selling a product or service.
Gross margins
The gross margin or gross profit is the net result of subtracting the cost of goods sold from net sales. This figure shows you how much money a company is making directly from sales before considering other operating costs. You calculate the gross profit by subtracting costs of goods sold from net revenue. The gross margin is a ratio calculated by dividing gross profit by net revenue. Watching year‐to‐year trends in gross margins gives you a good idea of a company’s profit growth potential from its key revenue sources.
You can calculate a gross margin ratio by dividing a company’s gross profit by its net revenue:
The gross margin ratio, expressed as a percentage, considers revenue from sales minus the costs directly involved in making those sales and is a good indicator of how well a company uses its production, purchasing, and distribution resources to earn a profit. The higher the percentage, the more efficient a company is at making its profit.
By comparing gross margin ratios among various companies within the same industry or business sector, you can get an idea of how efficient each company is at generating profits. Investors favor companies that are more efficient.
To give you an idea of how to use this ratio and others in this chapter, we compare figures from two of the leaders in the home‐improvement retail sector: Home Depot and Lowe’s. Tables 6‐1 and 6‐2 present the gross profits section from the past three annual income statements (information taken from Yahoo! Finance) for each company. Table 6‐3 compares the gross margin ratios for the two companies.
You can see that Lowe’s is slightly more efficient at using its production, purchasing, and distribution resources than Home Depot, because Lowe’s has consistently higher gross margin ratios. Both companies maintain their gross margin year to year with minimal change. The advantage of using this ratio, rather than the actual revenue and profit numbers for comparison, is that it makes comparing large companies with small companies within the same business or industry sector much easier. Even though Home Depot’s sale volume is considerably higher, the ratio enables you to compare how efficiently each company uses its resources.
Expenses
The next section of the income statement shows the expenses of operating the business, including the sales costs and administrative costs of business operations. When comparing a company’s year‐to‐year results, you need to watch for signs of whether expenses are increasing faster than a company’s gross profits, which can be an indication that a company is having a problem controlling its costs and doesn’t bode well for future profit growth potential.
When you see expenses drop from one year to the next while gross margins increase, that’s usually a good sign and means a company likely has a good cost‐control program in place. The potential for growth in future profit margins is good.
Gross profits and expenses that rise at about the same rate is neither a significant positive nor negative sign. When that happens, the best way to get a reading on how a company is controlling its expenses is to compare its expenses with the expenses of other companies in similar businesses.
Interest payments
The interest payments portion of the expense section of an income statement gives you a view of a company’s short‐term financial health. Payments shown here include interest paid during the year on short‐ and long‐term liabilities (more about those in the “Looking at debt” section, later in this chapter). These payments are tax‐deductible expenses, which help reduce a company’s tax burden.
To determine a company’s fiscal health, use the interest expense number and the earnings before interest and taxes (EBIT) number, which is usually shown on the income statement. If not, you can calculate it by subtracting interest and tax expenses from operating income (which is gross profit minus expenses, also usually shown on the income statement). You can use this figure to determine whether the company is generating sufficient income to cover its interest payments using the interest coverage ratio. You can calculate the company’s interest coverage ratio (expressed as a percentage, this ratio provides a clear‐cut indicator of a company’s solvency) using this formula:
Companies with high interest coverage ratios won’t have any problems meeting their interest obligations, and their risk of insolvency (going belly up) is low. On the other hand, a low interest coverage ratio is a clear sign that a company has a problem and may face bankruptcy. Whether an interest coverage ratio tends to run high or low depends a great deal on the type of industry or business a company is in. Comparing the interest coverage ratios of several companies in the same industry or business is the best way to gauge, or judge, the value of the ratios.
Table 6‐4 shows annual EBITs and interest expenses from three successive annual income statements for Home Depot, and Table 6‐5 shows the corresponding numbers for Lowe’s.
Both companies are in a good position to make their interest payments. Lowe’s currently shows no interest payments, so there is plenty of room to take on debt if needed. Home Depot has 7.7 times more income than it needs. Analysts generally consider a company in trouble whenever its interest coverage ratio falls below 3.
Tax payments
Corporations are always looking to avoid taxes, just like you. The income tax expense figure on the income statement shows the total amount that a company paid in taxes. A corporation pays between 15 percent and 38 percent of its income in taxes, depending on its respective size; however, corporations have many more write‐offs they can use to reduce their tax burdens than you have as an individual taxpayer. Most large corporations have teams of tax specialists who spend their days looking for ways to minimize taxes. When looking at tax payments, reviewing how well the company you’re interested in manages its tax burden compared with other similar companies is important.
Dividend payments
Companies sometimes pay a dividend, or part of the company profits, for each share of common stock that an investor holds. This dividend is distributed to shareholders usually once every quarter after the company’s board of directors reviews company profits and determines whether to pay and how much the dividend will be. Paying dividends is not a tax‐deductible expense for companies that pay them.
In the past, traders have preferred growth stocks that don’t pay dividends. However, recent changes in the way dividends are taxed may have altered the way traders view dividend‐paying stocks. Dividends are taxed at the same rate as ordinary income. Qualified dividends, dividends of a U.S. stock or foreign stock that qualifies, are taxed at a 0 to 15 percent tax rate. To collect a qualified dividend, you must hold the stock for at least 60 days prior to the ex‐dividend date, which is the date of record on which the shareholder will be paid. For example, if the ex‐dividend date is January 15 and you buy the stock on January 16, you’re not entitled to the dividends. The dividends go to the person who owns the stock on the ex‐dividend date.
Profitability
You now can use the income statement to quickly check your company’s profitability by using one or both of two ratios — the operating margin and net profit margin. The operating margin looks at profits from operations before interest and tax expenses, and the net profit margin considers earnings after the payment of those expenses.
You calculate operating margin using this formula:
You calculate net profit margin using this formula:
Table 6‐7 shows the gross profits, operating incomes, and earnings after taxes from three successive annual income statements for Home Depot, and Table 6‐8 shows the corresponding numbers for Lowe’s.
You can see from the numbers in Table 6‐9 that Home Depot did considerably better than Lowe’s in 2016. Both stores continued their recovery since the housing downturn of 2007, but Home Depot’s recovery is much stronger. In the previous edition of Trading For Dummies, we reported that Home Depot’s operating margin was 27.5 percent in 2012 and Lowe’s was 18.9 percent.
Looking at Cash Flow
When you review income statements, you’re looking at information based on accrual accounting. In accrual accounting, sales can be included when they’re first contracted, even before revenue from them is collected. Sales made on credit are shown even if the company still needs to collect from the customer. Expenses are recorded as they’re incurred and not necessarily as they’re paid. However, the income statement definitely does not show a company’s cash position. A company that’s booking a high level of sales can have a stellar income statement but nevertheless be having trouble collecting from its customers, which may put that company in a cash‐poor situation. That’s why cash‐flow statements are so important.
You can get an idea of your favorite company’s actual cash flows from the adjustments shown on its cash‐flow statement. The three sections to this statement are operating activities, financial activities, and investment activities. Cash‐flow statements are filed with the SEC along with income statements on a quarterly and annual basis.
Operating activities
Looking at cash flow from operating activities gives you a good picture of the cash that’s available from a company’s core business operations, including net income, depreciation and amortization, changes in accounts receivable, changes in inventory, and changes in other current liabilities and current assets. We talk more about these accounts in the later section “Scouring the Balance Sheet.”
Calculating cash flow from operating activities includes adjustments to net income made by adding back items that were not actually cash expenditures but rather were required for reporting purposes. Depreciation is one such item. Similarly, expenses or income items that were reported for accrual purposes are subtracted out. For example, changes in accounts receivable are subtracted out because they represent cash that hasn’t been received. Conversely, changes in accounts payable represent payments that haven’t yet been made, so the cash still is on hand.
The bottom line: This section of a company’s cash‐flow statement shows actual net cash from operations.Table 6‐10 compares three successive years of cash flow from operating activities at Home Depot and Lowe’s.
TABLE 6‐10 Total Cash Flow from Operating Activities*
Looking at the numbers in Table 6‐10, you can see that Home Depot’s cash position is on an upward trend, while Lowe’s cash position went down from 2015 to 2016. Both Lowe’s and Home Depot’s cash positions have topped their cash flow from operating activities prior to the housing crash. In 2007, Home Depot’s cash flow from operating activities was $7,661,000, and Lowe’s was $4,502,000.
For all companies, one of the largest adjustments to cash flow is depreciation. Depreciation reflects the dollar value placed on the annual use of an asset. For example, if a company’s truck will be a usable asset for five years, then the cost of that truck is depreciated over that five‐year period. For accounting purposes on its income statement, a company must use straight‐line depreciation, a method of calculating depreciation in which the company determines the actual useful life span of an asset and then divides the purchase price of that asset by that life span. Each year, depreciation expenses are recorded for each asset using this straight‐line method. Although no cash is actually paid out, the total amount of depreciation is added back to the cash‐flow statement.
For tax purposes, companies can be more creative by writing off assets much more quickly and thus reducing their tax burdens at the same pace. One type of write‐off — dealing with Section 179 of the Internal Revenue Code — enables a company to deduct the full cost of an asset during its first year of use. Other methods enable a company to depreciate assets sooner than the straight‐line method, but not as soon as the 100 percent permitted by Section 179. How a company depreciates its assets can have a major impact on how much that company pays in taxes.
Although you won’t know how a company depreciated its assets by looking at its cash‐flow statement, you’ll know the adjustment made for depreciation for cash purposes. Note that depreciation is an expense that must be reported on an income statement and is not a cash outlay.
Financing activities
The financing activities section of a cash‐flow statement shows any common stock that was issued or repurchased during the period the report reflects, and any new loan activity. The financial activities section gives you a good idea whether the company is having trouble meeting its daily operating needs and, as a result, is seeking outside cash. You won’t, however, find that new financing always is bad. A company may be in the process of a major growth initiative and may be financing that growth by issuing new debt or common stock.
The bottom line: This section of the cash‐flow statement shows a company’s total cash flow from financing activities. Table 6‐11 compares three successive years of cash flow totals from financing activities at Home Depot and Lowe’s.
TABLE 6‐11 Total Cash Flow from Financing Activities*
A negative cash flow from financing activities usually means that a company has either paid off debt or repurchased stock. In this case both Home Depot and Lowe’s repurchased stock in 2016. A positive cash flow here usually means new stock or debt was issued. Both companies issued new debt during this period as well. Obviously, many combinations of various financing activities can affect the bottom line, but the key for traders is to gain an understanding of why the change occurred and whether the company’s reason for making the change was solid enough to improve its profit and growth picture.
Investment activities
This section of the cash‐flow statement shows you how a company spends its money for growing long‐term assets, such as new buildings or other new acquisitions, including major purchases of property, equipment, and other companies. It also shows you a company’s sales of major assets or equity investments in other companies. Tracking investment activities gives investors a good idea of what major long‐term capital planning activities have taken place during the period.
The bottom line: This section shows a company’s total cash flow from investing activities. Comparing three successive years of investment activities by Home Depot and Lowe’s, Table 6‐12 indicates that both companies increased capital outlays in 2016 from 2015. Home Depot increased them at a faster pace. You would need to look closer at the notes to the cash‐flow statement to determine exactly how each company is investing its money.
TABLE 6‐12 Total Cash Flow from Investing Activities*
The balance sheet gives you a snapshot of a company’s assets and liabilities at a particular point in time. This differs from the income statement, which gives you operating results of a company during a particular period of time. A balance sheet has three sections, including
An assets section that details everything the company owns
A liabilities section that details the company’s debt or any other claims on the company’s assets made by debtors
A shareholder’s equity (also called owner’s equity) section that lists all the claims made by owners or investors
The balance sheet gets its name because the total assets of the company are supposed to equal the total claims against it — total liabilities plus total equity.
Assets and liabilities are listed on the balance sheet according to their liquidity, or how quickly and easily they can be converted into cash. Assets or liabilities that are more liquid appear first on the list, while the ones that are increasingly more difficult to convert to cash — long‐term assets or liabilities — appear later. The assets section is divided into current assets (the ones that are used up in one year) and long‐term assets (the ones whose life spans are longer than a year), as is the liabilities section — current liabilities and long‐term liabilities.
Current assets include cash and other assets that can quickly and easily be converted into cash — marketable securities, money market mutual funds, accounts receivables, and inventories. Long‐term assets include holdings such as buildings, land, and equipment. Similarly, on the liabilities side, current liabilities include any claims against assets that are due during the next 12 months, such as accounts payable and notes payable. Long‐term liabilities are claims due in more than 12 months, such as mortgage or lease payables.
Equity accounts include outstanding (remains on the market) preferred and/or common stocks and retained earnings. Retained earnings reflect the profits that are reinvested in the company rather than paid out to owners or shareholders.
Analyzing assets
In analyzing assets, two key ratios to look at are how quickly a company is collecting on its accounts receivable — the accounts receivable turnover — and how quickly inventory is sold — the inventory turnover.
You use a two‐step process to find the accounts receivable turnover. First you must find out how quickly a company turns its accounts receivables into cash, using this formula:
Then you need to find out how quickly a company collects on its accounts by dividing the accounts receivable turnover into 365 to find out the average number of days it takes to collect on accounts.
Testing for inventory turnover uses a similar two‐step process. First you must find out how quickly inventory turns over during the year, using this formula:
Then you need to divide the inventory turnover ratio into 365 to find out the average number of days it takes a company to turn over its inventory. Comparing these results for the companies you’re considering can help you determine how well each company is handling the collection of its accounts receivable and the sale of its inventory. Obviously, the faster a company collects on accounts or sells its inventory, the better that company is doing in managing its assets. You should compare companies in the same industry to determine how well a company is doing.
Whenever you see accounts receivable rising rapidly, and the number of days to collect on those accounts also is rising, that signals a red flag that indicates cash problems likely lie ahead. Whenever you see inventory numbers rising, a company can be having a hard time selling its product, which also raises a red flag, indicating problems ahead.
We’re summarizing these two common ratios so you know what they mean whenever you see them mentioned by analysts. As a trader, you aren’t likely to take the time to do these calculations yourself.
Looking at debt
When considering debt, or what a company owes, the two primary ratios you want to look at are the current ratio and acid or quick ratio. You can quickly calculate the current ratio, which tests whether a company can make its payments, by looking at the balance sheet and using this formula:
Again, like the other ratios in this chapter, you must compare the ratio of one company to that of other companies in the same industry. A current ratio that’s lower than most other companies in the industry can indicate the company is having a problem paying its short‐term debts, which, in turn, is a strong sign that bankruptcy may be just around the corner. A current ratio that’s significantly higher can be a bad sign too, because it can mean the company isn’t using its assets efficiently. For these reasons, traders like to see companies with current ratios that are close to the industry average.
Luckily, you won’t have to calculate current ratios, because they’re easily found on any website that includes fundamental statistics. Using Yahoo! Finance, we found that Home Depot’s current ratio is 1.30 and Lowe’s is 1.01.
The acid test, or quick ratio, is almost the same as the current ratio; however, the key difference is that inventory value amounts are subtracted from current assets before dividing that result by current liabilities. Many financial institutions take this extra step because inventories aren’t as easy to convert to cash. You calculate the acid test ratio by:
The acid test ratio is primarily of interest to financial institutions thinking about making a short‐term loan to a company. They look for an acid test ratio of at least 1 to 1 before considering a company a good credit risk. Even though as a trader you’re not likely to be in the business of making loans, a company that has problems getting short‐term debt is likely to have problems meeting its short‐term obligations in the near future. As the market recognizes the problem, the company’s share price is likely to drop.
Reviewing goodwill
Goodwill is not a tangible asset but rather is usually collected through the years as companies are bought and sold. Goodwill reflects a competitive advantage, such as a strong brand or reputation. When one company buys another and pays more than the tangible assets are worth, the difference is added to the acquirer’s balance sheet as goodwill. In other words, it’s the premium in price that one company pays for another.
Determining Stock Valuations
By now the key question you’re probably asking is, “How do I use all this data to decide how much I should pay for a stock?” Basically, a stock’s value is the amount buyers are willing to pay for the stock and the amount for which sellers are willing to sell the stock under current business conditions. A stock’s actual value shifts throughout the day and usually in a matter of seconds when the trading volume is high.
Fundamental analysis is one of the tools that investors and some traders use to analyze earnings, revenue growth, market share, and future business plans so they can determine a stock’s value and the price for which they’re willing to pay or sell. Earnings and earnings growth are key factors and are considered a part of fundamental analysis. Common ratios used to determine a stock’s value or performance include the price to earnings multiple, or P/E ratio; price to book multiple, or price/book ratio; return on assets (ROA); and return on equity (ROE). We talk more about how these ratios are calculated in the sections that follow.
After considering all this data, investors decide whether a company’s stock is undervalued or overvalued. Although past performance is no guarantee about a company’s or stock’s future success, fundamental analysts believe collecting and analyzing the appropriate data enables investors to make more‐educated guesses about a stock’s value.
Earnings
Using the income statement, we’ve talked extensively about a company’s earnings. Remember, the three types of earnings figures to consider are
Gross profit, which is calculated after considering the direct costs related to sales
Operating income, which shows a company’s profit after subtracting operating expenses
Net income, which is the bottom‐line earnings after all expenses, taxes, and interest are subtracted
When you encounter discussions about earnings figures, be certain that you know which types of earnings are being discussed for the stock you’re eyeing. To be able to compare apples with apples, you must know that you’re using the same type of earnings figures.
Earnings growth rate
The earnings growth rate, which shows how quickly the company is expected to grow, isn’t something you calculate. What you’ll find in the fundamental‐analysis statistics for stocks are earnings growth rate projections made by industry analysts based on their analysis of a company’s potential earnings. The earnings growth rate is included on all the websites that we mention in Chapter 4 that provide fundamental statistics. When looking for this data, be sure to check out the earnings growth rate potential at a number of those sites.
Continuing the comparison of Home Depot and Lowe’s, Yahoo! Finance projected
Home Depot’s earnings growth rate for 2017 to be 4.5 percent
Lowe’s earnings growth rate for 2017 to be 5.2 percent
Clearly, at this point in time, analysts believe Lowe’s will grow at a slightly faster pace than Home Depot in 2017.
Figuring Your Ratios: Comparing One Company’s Stock to Another
In this section, we show you how to calculate four key ratios — P/E, price/book, ROE, and ROA — but luckily you can find all these where fundamental statistics are reported (newspapers, websites, and so on — see Chapter 4 for more). Each of these ratios gives you just one more piece in the puzzle of determining how much you want to pay for a stock. By comparing each of the ratios for each of the companies you’re considering, you can make a more educated case about the price you want to pay for any stock.
Price/earnings ratio
The P/E ratio is probably the one that’s quoted most often in news stories. This ratio reflects a comparison of a stock’s earnings with its share price. You calculate this ratio using this formula:
You’ll probably find two types of P/E ratios for a stock. The trailing P/E is based on earnings reported in previous quarters, and the forward P/E is based on projected earnings.
At Yahoo! Finance as of market close on March 28, 2017, the trailing P/E for Home Depot was 22.82, and its forward P/E was 18.08. Lowe’s trailing P/E was 23.75, and its forward P/E was 15.61. There isn’t much difference in the trailing P/E ratios for Home Depot and Lowe’s, but analysts seem to favor Home Depot with a higher forward P/E.
Historically, market analysts believed a P/E ratio of 10 to 15 was reasonable. For a while, much higher P/Es were tolerated, and current market conditions appear to be trending back to the higher P/Es, but many people expect that a market correction is coming.
When comparing companies, you can get a good idea of how the market values each stock by looking at its P/E ratio. Although the P/E ratio is actually a percent, it’s rarely stated that way. However, you’ll sometimes hear it called a price multiple because the P/E ratio represents how much you’re paying for each dollar of a company’s earnings.
Price/book ratio
The price/book ratio compares the market’s valuation of a company to the value that the company shows on its financial statements. The higher the ratio, the more the market is willing to pay for a company above its hard assets, which include its buildings, inventory, accounts receivable, and other clearly measurable assets. Companies are more than their measurable assets. Customer loyalty, the value of their locations, and other intangible assets add value to a company. Investors looking to buy based on value rather than growth are more likely to check out the price/book ratio. You calculate price/book ratios using this formula:
Lowe’s price/book ratio at Yahoo! Finance was 8.54, and Home Depot’s was 23.27. Based on price/book ratio, the market is willing to pay a higher premium for Home Depot’s stock.
Return on assets
Return on assets (ROA) shows you how efficiently management uses the company’s resources. ROA, however, doesn’t show you how well the company is performing for its stockholders. To calculate return on assets, use this formula:
Home Depot’s ROA at Yahoo! Finance was 17.94 percent; Lowe’s was 10.8 percent. Home Depot is doing a more efficient job using its resources based on those two ROA numbers.
Return on equity
Investors are more interested in return on equity (ROE), which measures how well a company is doing for its shareholders. This ratio measures how much profit management generates from resources provided by its shareholders. Investors look for companies with high ROEs that show signs of growth. You calculate ROE by using this formula:
Home Depot’s ROE was 97.29 percent, and Lowe’s was 35.62 percent.
The ROEs show that Home Depot is doing a better job for its shareholders, which, again, is reflected in the price investors are willing to pay for its shares. As of November 16, 2016, Home Depot’s stock price was $125.33, and Lowe’s was $67.02.
As a trader, you may not make your buy and sell decisions based on fundamental analysis, but collecting and having access to this information as part of your arsenal certainly helps you make better and more informed stock choices. Knowing a company has strong fundamentals helps to back up what you’re seeing in the technical analysis (see Part 3). If you’re trying to decide between two stocks whose technical charts are positive, you can use the fundamental analysis to tip the scale toward your best trading opportunity.
Adding up the income
You can read any public company’s financial reports at the Edgar website (
most companies show only net sales on their income statements. From these figures, you want to see obvious signs of steady growth in revenues. A decrease in revenues from year to year is a red flag that indicates problems and that it’s probably not a good potential trading choice.
The next section of the income statement shows the expenses of operating the business, including the sales costs and administrative costs of business operations. When comparing a company’s year‐to‐year results, you need to watch for signs of whether expenses are increasing faster than a company’s gross profits, which can be an indication that a company is having a problem controlling its costs and doesn’t bode well for future profit growth potential.
Companies with high interest coverage ratios won’t have any problems meeting their interest obligations, and their risk of insolvency (going belly up) is low. On the other hand, a low interest coverage ratio is a clear sign that a company has a problem and may face bankruptcy. Whether an interest coverage ratio tends to run high or low depends a great deal on the type of industry or business a company is in. Comparing the interest coverage ratios of several companies in the same industry or business is the best way to gauge, or judge, the value of the ratios.
