All businesses have fundamentals. Fundamentals are basic, measurable facts about a business that help tell insiders (i.e., management) and outsiders (i.e., investors) how things are going. Fundamentals are to a business what the instruments in an airplane cockpit are to an airplane—airspeed, altitude, attitude, fuel consumption, fuel in the tank, and direction being the most important. Any deviance from the norm in any fundamental signals a need for corrective action. If all fundamentals are falling apart at once, you’re in a whole lot of trouble.
Most business fundamentals come forth as financial, or dollar-denominated numbers. Some compare other measurable operational numbers to something financial—for example, sales per square foot in the retail industry. Fundamentals can be represented in dollars (e.g., inventories) or percentages of dollars (profit margin) or ratios (sales per employee).
Your job, as you set out to acquire a business and to own it, is to understand the financials and what drives the company’s success. Your job, as a current or future business owner, is to decide:
• Are the financials what they should be?
• Are they getting better or worse?
• Would you want to own the business?
Business fundamentals can measure anything about a business, but usually measure something about assets, liabilities, revenues or expenses in the business, or the relationship among more than one of these. For example sales per square foot is an efficiency measure measuring the amount of revenue per unit of floor space, an asset.
The hundreds of things you could possibly measure would take a huge amount of time, and most, such as sales per delivery truck owned, would be meaningless. For many it would be hard for you to decide what was “good” or “bad.” Here’s where being an investor is better than a manager directly involved in the business—you don’t have to look at much, just a few key strategic fundamentals to judge a company’s performance by.
Strategic fundamentals can tell you if the business is doing well, if it is on track, and even more importantly, can signal whether things are getting better or worse.
Financial statements provide a record of a company’s performance, that is, how much it sold, what it cost to produce those sales, what it owns as assets to conduct the business, and what it owes to others. Almost all financials look to the past. They reflect past performance, although some, like long-term debt, suggest something about future performance.
The sharp business manager and investor alike understand the past and the measurements of that past. A business with a poor past or current performance is suspect from the beginning, but even a superb performance in the past doesn’t guarantee future success (I’ll cite again the Eastman Kodak example).
So financial fundamentals—even the most strategic ones—are at best only part of the story. One must also look at the intangibles, the characteristics of the firm in regard to its marketplace, its management, sales channels, and so forth, to get a complete picture (as we will in Habits 12–15). Tomorrow’s intangibles become yesterday’s financials.
At the end of the day, financial fundamentals reveal the strength of two key intangibles:
1. How strong the company is in its marketplace
2. How effectively management converts that strength into profits
Savvy investors get into the habit of reading both of these qualities.
GETTING REAL: A FEW WORDS ABOUT THE “MAGIC” OF ACCOUNTING
Accounting is the language and process of measuring business activity. Most business fundamentals arise from accounting processes.
Contrary to public perception, accounting for business assets and activity is not always a precise science. In fact, there can be quite a bit of art involved in accounting, especially for business assets and business income. As a result, reading financial statements can become one of those “let the buyer beware” exercises.
Why? Because, while the purchase price for most “physical” assets is known, the value of those assets over time is a subjective calculation. There are many assets, such as intellectual property, that elude precise evaluation altogether. How much is a patent worth? How much is an acquired business worth? Just like a stock you buy, you know what you paid for it, but how much is it really worth in terms of future returns to the acquiring company? It’s a fairly subjective number.
Likewise, reported net income can also be somewhat subjective. How much depreciation expense was taken against assets and thus against income? How much “expense” was taken to write down intangible assets such as patents and other intellectual property? How much “restructuring” expense was incurred? The rules give the accountants and corporate management considerable flexibility to “manage” reported earnings as well as asset values: what you see may not always be what you get.
The bottom line is this: while assets and income probably have some subjectivity in their valuation, debts are quite real, and so is cash. Debts must be paid sooner or later; there is no subjectivity or “art” to their valuation. Likewise, cash is cash, the stuff in the proverbial drawer, and is a take-it-or-leave-it, like-it-or-not fact of life or death for a business.
Thus we look at assets and income as important measures of business activity but know that there’s some subjectivity in those measures. At the same time, we look at debts, cash, and cash flow in and out of the business as absolute; neither cash nor debts lie. So we hang our valuation hats on cash and debt where we can.
There is more about this in Habit 11: Look for Cash in All the Right Places.
An “acid test” is a quick indicator, or measure, of a chemical reaction or process. You may choose to develop your own list of “acid tests” of the strategic fundamentals of a company. These tests should be applied before buying and while owning the company.
Profit Margins—Healthy, Better, or Worse?
I like profitable companies; who doesn’t? But what really counts is the size of the margin and especially the growth. If a company has a gross margin (sales minus costs of goods sold) exceeding that of its competitors, that shows that it’s doing something right, probably with its customers and/or with its costs. But unfortunately, it isn’t that easy. Competitive analysis is elusive; it’s hard to find a dependable source of “industry” gross margins, and comparing competitors can be difficult because no two companies are exactly alike; it’s easy to mix apples and oranges.
I like to see what direction gross margin is moving in—up or down. A growing gross margin signals that the company is doing something right. A declining gross margin suggests stronger competition, higher input costs, or less-effective management. It also makes sense to consider the economic context: in a poor economy, companies that can protect their margins will come out ahead.
Incidentally, the Value Line Investment Survey research reports are an excellent way to track margin progress over time.
Does a Company Produce More Capital Than It Consumes?
Make no mistake about it, I like cash. And pure and simple, I like it when a company produces more cash than it consumes.
At the end of the day, cash generation is the simplest measure of whether a company is successful, especially over the long term. Sure, if a company buys an airplane or opens a factory or a bunch of stores in a given quarter, it will be cash-flow negative. But that should be a temporary thing; over the long haul, it should produce, not consume cash.
Companies that continually have to borrow or sell shares to raise enough cash to stay in business are on the wrong track. How do you determine this? You’ll have to become familiar with the Statement of Cash Flows or equivalent in a company’s financial reports. Again, see Habit 11: Look For Cash in All the Right Places.
Are Expenses in Line?
Just like your household, company expenses should be prudently managed and under control. Anything else, especially without explanation, is a yellow flag. The best way to test this is to check whether the “Selling, General, and Administrative” expenses (SG&A) are rising, and more to the point, are they rising faster than sales? If so, that’s a yellow (not necessarily a red) flag, but if it continues, it suggests that something is out of control, and it will catch up with the company sooner or later.
In the recent recession, companies that were able to reduce their expenses to match revenue declines came out ahead. In more prosperous times, companies that grow expenses more slowly than sales become more profitable, As a result, they will be less vulnerable to the next downturn.
Does Working Capital Track the Business?
Working capital is a hard concept to grasp—even for small entrepreneurs who live with its ups and downs on a daily basis. Insufficient working capital is one of the biggest causes of death for small businesses, and working capital, especially changes in working capital, can signal success or trouble.
Using a simple analogy, working capital is the circulatory lifeblood of the business. Money comes in, money goes out, and working capital is what circulates in the veins in between. In its purest sense, it is cash, receivables, and inventory, less short-term debts. It’s what you own less what you owe, aside from fixed assets such as plant, stores, and equipment.
If receivables are increasing, that sounds like a good thing—more people owe you more money. But if receivables are rising and sales aren’t, that suggests that people aren’t paying their bills, or worse, the business has to finance more to achieve the same level of sales. Similarly, a rise in inventory without a rise in sales means that it costs the business more money—more working capital—to do the same amount of business. Unless the firm is lucky, more inventory means more obsolescence and potentially more deep-discount sales or write-offs down the road – a double whammy.
So a sharp investor will check to see that major working capital items—receivables and inventory—aren’t growing faster than sales. Indeed, a company that generates more sales without increasing working capital is becoming more efficient.
Does the Company Have Too Much Debt?
As with many other “fundamentals” items, you can tear your hair out looking at debt figures and trying to decide whether they’re in line with asset levels, equity levels, and industry norms. A simpler test is to check and see whether long-term debt is increasing or decreasing. In particular, you should look at whether it is increasing faster than business growth. Gold stars go to companies with little to no debt and to companies able to grow without issuing mountains of long-term debt. No debt on the balance sheet at all? That’s usually a good thing.
Does the Company Report Consistently Good Results?
We enter the danger zone here, because the management of many companies has learned to “manage” earnings to provide a steady improvement, always “beating the street” by a penny or two. So stability is a good thing for all investors, and companies that can manage toward stability get extra points. It’s worth checking for, but with the proverbial grain of salt.
Still, a company that is able to manage its sales, earnings, cash flow, and debt levels more consistently than competitors, and perhaps more consistently than what would be suggested by the ups and downs of the economy, is desirable—or at least more desirable than the alternatives.
Get Into the Habit
• Remember that fundamentals are the scorecard of the past, while intangibles such as brand and marketplace, and management excellence foretell the scorecard of the future.
• Keep in mind that fundamentals measure absolute business performance, relative performance over time (trends), and efficiency.
• Use fundamentals as a measure of (1) how strong a company is in the marketplace and (2) how effectively management converts that strength into profits.
• Develop your own list of “strategic fundamentals” (starting with the one provided, if you want). Use that list as an “acid test” for companies you own or evaluate to buy.