To make money, buy some good stock, hold it until it goes up, and then sell it. If it doesn’t go up, don’t buy it.
—WILL ROGERS
I have discussed a wide range of topics, and my goal is that you should fully understand the purpose of value investing and how it can be used. You also should keep in mind that regardless of your goals, you can invest your own money without the use of a money manager. Now that you understand value investing as a strategy, it’s time to dig into the most important area of becoming a successful long-term value investor—fundamentals.
The fundamentals of a company are what drive the long-term direction of a stock. Exercising the practice of research and identifying all data relevant to a company are the essence of fundamental analysis. Fundamental analysis often can be very tricky and over-whelming because there are so many areas of research for a particular company. In fact, you could spend hours researching all the data associated with a company’s day-to-day operations. Nearly all investment strategies use some form of fundamental analysis. Over the next several chapters I am going to take you inside the fundamentals of a company to help you identify the most important areas so that you will not become overwhelmed with the data.
Investors break fundamental analysis into three areas: income statement, balance sheet, and cash flow. The income statement is perhaps the most often used among investors because it reflects both quarterly and yearly financial data of a company. The balance sheet summarizes a company’s cash, total assets, equity, and liabilities for a specific period of time and in my opinion should be the first area of research into a company’s performance. The statement of cash flow shows the amount of money that is generated and used by the company. As I discuss these three statements, I will go over terminology to help limit any confusion. Although there are numerous pieces of data, I will not go through every piece, but I will better explain the data that is most beneficial in my analysis and has led to my own success.
A company’s income statement is the best and easiest way to judge that company’s operational progress over a period of time. This piece of data is the single largest market mover for a particular stock. Every quarter, a number of analysts will predict a company’s top- and bottom-line results, which means revenue and profit. Both pieces of data are part of the income statement. When a company exceeds expectations, it most likely trades higher, but when a company falls short of expectations, then theoretically the stock will fall lower because it is supposed to be priced according to earnings guidance. Most of the time, though, when you hear people discussing fundamental data, they are discussing information from an income statement. Although there are several events that ultimately can affect the price of a stock, a company’s income statement usually reflects stock performance.
In an early chapter I discussed expectations and explained that the market moves up and down as one’s expectations rise or fall. When market data, such as a real gross domestic product or employment, are stronger than what we expect, the market moves higher. But when data are below our expectations, the market moves lower until the actual data exceed expectations. The same event occurs with an individual company. We set expectations, and when expectations are exceeded, the stock trades higher. This fact is why it’s so important to fully understand fundamentals, along with market psychology (which I will discuss later).
Let’s take a look at basic fundamental data from an income statement, and I will explain how I use the data as a value investor.
Revenue is the amount of money that a company receives during a specific period of time as a result of business activities. This measure on an income statement is one of the most important pieces of data to investors and is referred to as the top-line number. When a company announces earnings or the media talks about top-line growth, they are referring to the level at which the company grows revenue over a period of time. This number is important to me as a value investor because it symbolizes growth within the company. My theory is that a company can always figure out a way to cut costs or manipulate taxes, but creating revenue is much more difficult. Therefore, I prefer a company with a large amount of revenue compared with its valuation.
The costs of a company are measured in many areas, but rather than take you inside each of these categories, I will explain costs as one category. As a person, you are fully aware of the definition of costs, but in accounting and business, costs are divided into several sections on an income statement. For example, there is a section for selling, general and administrative expenses (SG&A), which are the operational expenses of the company, and they reflect the efficiency of management. Some analysts like to use this particular category of costs as a percentage of total sales to better understand management’s efficiency and then track the percentage over a period of time. In addition, a company’s cost of goods sold (COGS) is measured to better understand the costs associated with the production of a company’s goods. Finally, I personally like to associate special items with a company’s costs. A company’s special items, which are sometimes referred to as extraordinary expenses or nonrecurring items, are supposed to be one-time expenses that may affect earnings for a particular quarter. These one-time costs are very important because they can distort the value of a company. Therefore, when looking at the fundamentals, I suggest identifying any large special items. Don’t think of them as a negative reflection on the company but rather as a necessary charge that won’t affect the company in the following year. In the end, costs are a measure that must be identified and a trend that must be carefully observed. Later I will discuss margins that take into account costs, which I feel is a better way to identify trends and the attractiveness of an investment.
My favorite measure for growth is revenue, but the markets prefer net income. Net income is the amount of money that a company has, minus expenses, or revenue, minus expenses. It shows how profitable a company is during a specific period of time. Owning a company with a large amount of net income is important because net income ultimately means a stronger balance sheet, which could mean further growth. If a company is not profitable, it obviously will not post net income but will post net loss in its place. This is the amount the company lost, after costs from revenue. Net income is very important to the valuation of a company, but as a value investor, I would prefer a profitable company with a greater amount of revenue. A company can easily close offices and lay off employees to return more income, but sooner or later it will reflect as a loss of revenue unless the operations remain consistent.
A company’s pretax income is similar to net income, but it’s the amount of income prior to taxes. I pay close attention to this particular measure because of the extent to which taxes can be manipulated by a publically traded company.
The earnings per share (EPS) of a company are perhaps the most important measure to determine the price of a stock. It also goes hand in hand with several important stock metrics. The number most likely reflects the net income of a particular company, but it also takes into account dividends, equity, and the total number of shares. Therefore, the EPS of a $10 billion company may be the same as that of a $1 billion company because the numbers of shares outstanding are different. There is also a possible difference in dividends. As a result, you can’t compare the EPS of two different companies, but you can compare a company’s EPS performance over a period of several years. This is a very important metric to all investors and is sometimes referred to as the company’s bottom line.
A company’s profit margin isn’t something you will necessarily see on that company’s income statement, but it can be easily calculated and is very important. The profit margin is how much of every dollar is profit from the company’s revenue. It’s the net income divided by revenue. This percentage gives you valuable information about the effectiveness of management and the future performance of the company.
For example, let’s say a company posts quarterly revenue of $1 billion and a net income of $200 million. Its profit margin would be 20 percent. Now let’s say that the company posts revenue of $1.5 billion the following year, during the same quarter, with $255 million in net income. At first glance, the company looks good, with revenue and earnings both increasing, and with this level of growth, the stock may increase. However, the profit margin declined to 17 percent, which means that costs are growing faster than sales. The important thing to remember is that this number is not significant unless it occurs for several quarters or several years in a row. Sometimes a company has to spend money to make money, and if the company endures one quarter of decreased margins to have several quarters of increased margins, then it could be a great investment. You just have to make sure that profit margins are either sustained or improving because they measure the costs of a company.
The operating margin of a company can be measured on a quarterly or yearly basis and is similar to the profit margin. It’s used most often as a way to determine how much a company makes per dollar before taxes or interest. Much as with profit margin, the goal of watching this fundamental indicator is to compare its performance over a period of time. I don’t typically look at a company’s operating margin over a period of quarters, but I do keep track of operating margins over a period of several years. The goal is to make sure that over time this margin is rising with revenue, and the company is becoming more profitable.
Another great way for an investor to use operating margins is to compare two or more companies in similar industries. You may be considering two fast-growing companies in the same industry as a potential investment. When you compare the margins for each company, you may find that one’s margins are growing faster than the other’s or that one’s margins are actually declining. Using both operating and profit margins is a good way to determine the costs for a company, as well as its effectiveness. I don’t necessarily care how high the margins are for either profit or operations, but I do care whether or not they are positive and that over a period of several years they are improving, not declining.
I am one of the biggest endorsers of Google Finance. The most popular investment research site is probably Yahoo! Finance, but I prefer to use Google Finance on a daily basis when comparing the fundamentals of a company. Since I am a big endorser of Google products, I am going to use the information obtained from Google’s income statement to show you how to make an educated investment decision based on the information that I have discussed.
Before I put all the information together, you may notice that there are some areas of the income statement that I failed to mention. My goal, as a value investor and someone teaching you how to improve your returns significantly, is to simplify investing. I talked about complexity, and I am not trying to convince you that I am smarter than you or know the most complex systems for success, but I do want to give you the most effective and simplest road to success that will improve your returns without the complex schemes of any broker. I am yet to discuss several key areas involved in making an investment decision, so I don’t want you to worry or get overwhelmed with the countless ways of analyzing a company’s income statement. The areas just discussed tell you everything that you need to know about a company’s income statement. One piece of information gives you knowledge regarding all other areas of a company’s day-to-day operations. With that being said, let’s dig deeper and put it all together in order to help you make an educated investing decision based on the income statement alone without worrying about any other aspect of investing.
Figure 5.1 illustrates the amount of revenue and net income over a four-year period for the company Google. As you can see, the company has returned more revenue year over year along with significant jumps in net income. Identifying both revenue and net income should be the first piece of fundamental research that goes into any investment. You may find a company that is growing in both revenue and net income but later find another reason why it may or may not be a good buy. However, if you know that a company is growing, that’s your first sign that it could be a candidate for an investment.
Figure 5.1 Google (NASDAQ: GOOG) income and revenue growth.
After you have identified that a company’s revenue and income have grown over a period of several years, it’s time to turn your attention to the profit and operating margins. These margins will take into account the company’s costs and will give you a better idea of how it may perform in the future. It’s important to know the difference between a profit and an operating margin. A profit margin is determined by a company’s net income, which is after taxes. An operating margin is determined by the company’s operating income, which is prior to taxes. Any significant changes in one margin and not the other could identify a change in the amount paid in taxes or some other type of accounting change. Therefore, when I am comparing the operating and profit margins over a long period of time, I look for consistency between the two margins.
We have already established that Google is growing both in revenue and net income, but what is interesting is that Google’s margins declined from 2010 to 2011, with a steep decline in operating margins (Figure 5.2). Prior to 2010, the company’s margins had improved year over year, but they did slow gradually between 2009 and 2010. This could be an indication of a long-term problem. One year of declining margins is not enough to abandon a potential investment, but it definitely should be noted. If it continues over a period of several years, it probably means that spending is exceeding revenue, and the effectiveness of the company is regressing. Therefore, the company may not be best suited for a long-term investment until we identify some level of stability.
Figure 5.2 Google (NASDAQ: GOOG) margins over a four year period.
In addition to using a company’s full-year progress, its quarterly progress should be charted as well. When comparing a company’s quarterly progress, you can’t compare the first quarter with the second quarter; you must compare year over year. For example, quarter 4 (Q4) of 2011 should be compared with Q4 of 2010. Seasonal peaks for companies in certain industries cause them to perform better during certain quarters. It wouldn’t be accurate to compare the third- and fourth-quarter results of Sears because the company posts such large sales during its fourth-quarter holiday season. You could, however, compare the revenue, earnings, and margins of the fourth quarter for each of the last few years; this would determine whether or not the company is growing, along with the margin that it is growing.
As I begin to discuss fundamentals, which can become very confusing, my goal is to simplify the process so that you can make good investment decisions without becoming overwhelmed. As I end each section, I will reiterate the most important information that you should use while considering making an investment.
An income statement contains the most important data for analyzing a stock’s immediate trend. When a company announces earnings and trades above or below a range, it’s most likely because of its top- or bottom-line growth. Therefore, when you are choosing an investment, you need to compare the company’s performance year over year in revenue and net income.
It’s pointless for you to consume yourself with every number on an income statement. One of the most important things you need to consider is how fast the company is growing and whether the margins are sustained or improving over a period of time. A company’s margins will give you other information that you will need from an income statement. It will give you an idea of how much the company is paying in taxes, its total costs, and how much it is spending to create additional revenue. Also, beware of any one-time special items on an income statement that may affect margins and earnings for a particular quarter. Do not use this as a reflection of the company’s quarter but rather subtract the special item and then identify the company’s income prior to the large cost. An income statement is very important in finding a good value investment, but it’s only one piece of the puzzle. As we progress, read over and familiarize yourself with any metric you don’t understand. If you need a term explained further, refer to investopedia.com, a reference site that is filled with definitions and explanations of investing terms and phrases.