There are several ways to analyze a security to decide whether it’s a good investment. Most approaches fall into two broad categories:
This chapter focuses on fundamental analysis, which evaluates a company by examining its financial condition. This traditional approach looks closely at items like revenues, expenses, debt levels, and product and/or service lines.
Publicly traded companies must disclose financial information on a regular schedule. Analysts use these disclosures to evaluate the company, and stockholders can inspect the company’s books and records through these filings:
10-K annual report
10-Q quarterly report
In these reports, fundamental analysts review financial statements to estimate a company’s value. The most commonly analyzed documents are:
Balance sheet
Income (cash flow) statements
There are small differences between income statements and cash flow statements, but the exam generally does not cover them. Keep it simple and assume both provide the same information.
A balance sheet is often easier to understand if you start with a personal example. You could create a personal balance sheet by listing:
The difference between the two is your net worth. For example:
| Assets | Liabilities | Net worth |
|---|---|---|
| $250k home | $200k mortgage | |
| $20k car | $10k car loan | |
| $5k cash | ||
| $275k | $210k | $65k |
This person has $275,000 of assets and $210,000 of liabilities, leaving $65,000 of net worth.
Companies track assets and liabilities in the same basic way (just with many more categories and line items). That’s why balance sheets are a key tool for estimating a company’s overall value.
Corporate balance sheets are more detailed, but the structure is the same. You don’t need to be an accounting expert for the exam, but you should be comfortable with the basics. Here’s a simplified example:
Current assets = $125,000
Fixed assets = $350,000
Intangible assets = $50,000
Current liabilities = $100,000
Long-term liabilities = $150,000
Stockholder’s equity = $275,000
This can look like a lot at first, so focus on the main categories and what they mean. Here are the balance sheet items you’ll want to recognize:
Current assets and liabilities
“Current” means short term (generally within one year).
Fixed assets
These are long-term tangible assets, such as real estate, property, vehicles, and equipment.
Intangible assets
These are long-term non-physical assets, such as trademarks, patents, copyrights, and other intellectual property.
Long-term liabilities
These are obligations that extend beyond one year, such as longer-term loans, bonds, and mortgages.
Stockholder’s equity
Equity represents ownership. Stockholder’s equity commonly includes outstanding stock, capital in excess of par, and retained earnings.
Balance sheets ultimately show a company’s net worth, also called stockholder’s equity. The formula is:
Can you calculate the net worth using the total assets and liabilities above?
The process is straightforward: add up total assets, add up total liabilities, and subtract liabilities from assets.
Balance sheets also support several common formulas that use current assets and current liabilities to measure a company’s liquidity (how easily it can access cash to meet short-term obligations).
Current assets typically include cash, cash equivalents (like money markets), accounts receivable, and inventory. Accounts receivable are payments for goods or services the company expects to receive soon. In other words, if the company has cash (or something that can reasonably be turned into cash soon), it’s usually classified as a current asset. These are the current assets from the earlier example:
Current assets = $125,000
Current liabilities typically include accounts payable, wages payable, taxes payable, and interest payable. These are bills the company must pay within a short period of time. They can relate to the cost of goods, operating costs (general business costs), interest costs on outstanding loans (including bonds), and taxes. If an obligation must be paid within a year, it’s generally classified as a current liability. These are the current liabilities from the earlier example:
Current liabilities = $100,000
The current ratio compares current assets to current liabilities. Companies use it to evaluate their ability to meet short-term obligations.
A personal analogy helps: the current ratio is like asking whether you could cover a large unexpected bill using the resources you can access quickly.
The formula is:
Using the example above, can you calculate the current ratio?
In general, it’s better to have more current assets than current liabilities.
Another common measure is net working capital. Instead of a ratio, it gives a dollar amount showing the net short-term resources available.
Using the same numbers as above, can you calculate net working capital?
Here, the company has $25,000 more in current assets than current liabilities. That amount can help cover unexpected short-term obligations.
The term “quick” refers to short-term finances. The quick formulas below are designed to measure liquidity. The more liquid a company is, the more cash and marketable assets it has available when an unexpected payment comes due.
First is the quick assets formula:
This removes inventory to focus on assets that are typically easier to convert to cash quickly. Inventory may not help much in a sudden cash need (unless the company can sell its products quickly).
Next is the quick ratio, also called the acid test ratio. This is a common liquidity measure because it compares quick assets to short-term liabilities.
In general:
Now let’s look at an income statement. If you’ve ever tracked money coming into and going out of your bank account, you’ve seen a personal version of this idea.
Income statements focus on inflows and outflows of money. For example:
| Event | Amount |
|---|---|
| Paycheck from job | $3,000 |
| Groceries | -$100 |
| Mortgage payment | -$1,500 |
| Total | +$1,400 |
This simple personal income statement shows $1,400 of positive cash flow after these three events.
Companies report income and expenses in a similar way, but with many more line items. Analyzing income statements helps you evaluate how well a company sells its products and services and how effectively it manages its costs.
Like the balance sheet, a corporate income statement is more detailed. Here’s a simplified example:
| Line item | Amount |
|---|---|
| Sales revenue | +$200,000 |
| Cost of goods sold (COGS) | -$80,000 |
| Gross profit | $120,000 |
| Operating expenses | -$30,000 |
| Income from operations (EBIT)* | $90,000 |
| Interest (bonds & loans) | -$25,000 |
| Income before taxes (EBT)* | $65,000 |
| Taxes | -$10,000 |
| Net income | $55,000 |
| Dividends paid | -$20,000 |
| Retained earnings | $35,000 |
*EBIT = earnings before interest & taxes
*EBT = earnings before taxes
This statement shows that the company generated $200,000 in sales revenue and ended with $55,000 of net income after paying for inventory, operating expenses, interest, and taxes. After paying $20,000 in dividends, it retained $35,000.
For the exam, it’s more important to recognize what types of items appear on an income statement than to memorize every line item.
Financial statements don’t always explain why a number changed. For example, if a company reports a sharp increase in cost of goods sold compared with prior periods, you’d want to know the reason.
When additional detail is needed, companies provide it in the footnotes to the financial statements. For example:
Cost of goods sold (COGS) increased by 250% due to costs related to COVID-19 safety measures. Additional capital was spent on various items, including additional personal protective equipment (PPE), additional liability insurance, and cleaning supplies.
One important formula uses earnings (profits) to help evaluate the value of a company’s stock.
Price to earnings (PE) ratios help investors judge whether a stock may be overvalued or undervalued.
In general, a higher PE ratio suggests the stock may be more expensive relative to its earnings. For example, a PE ratio of 100 means the market price is 100 times the company’s annual earnings per share. Unless the company grows significantly, that price may be difficult to justify.
On average, PE ratios often fall in the 15-25 range, depending on the company and industry.
Growth companies typically have higher PE ratios. These companies are expected to expand and generate larger profits in the future. As a result, the stock may look “expensive” today, but investors may be willing to pay more based on expected growth.
Value companies typically have lower PE ratios. These companies are often large, well-established, and have a long track record of profits. Because investors may not expect dramatic growth, they’re generally less willing to pay a high multiple of current earnings.
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