Fundamental analysis
There are several ways to analyze a security to decide whether it’s worth investing in. Most approaches fall into two broad categories:
- Fundamental analysis
- Technical analysis
This chapter focuses on fundamental analysis, which evaluates a company by examining its financial condition and business performance. This is the traditional approach to analysis, and it looks closely at items such as:
- Revenues and expenses
- Debt levels
- Product and/or service lines
Publicly traded companies must disclose financial information on a regular schedule. Analysts use these disclosures to gather the data they need. Stockholders also have the right to inspect a company’s books and records, and that right is largely satisfied through required filings such as:
10-K annual report
- Audited financial report
- Example: Tesla 10K filing
10-Q quarterly report
- Unaudited financial report
- Example: Microsoft 10Q filing
In these reports, fundamental analysts review financial statements to estimate a company’s value. The most commonly analyzed documents are:
Balance sheet
- Compares assets and liabilities
- Assets - liabilities = net worth
Income (cash flow) statements
- Displays income and expenses
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.
Balance sheets
It’s often easier to understand financial statements by thinking about them in personal terms. You could create a personal balance sheet by listing:
- Your assets (things you own)
- Your liabilities (things you owe)
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 so useful in fundamental analysis: they help analysts estimate 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 basic categories. Here’s a simplified example:
Assets
Current assets = $125,000
- Cash and cash equivalents - $100,000
- Accounts receivable - $15,000
- Inventory - $10,000
Fixed assets = $350,000
- Real estate - $150,000
- Equipment - $80,000
- Land - $120,000
Intangible assets = $50,000
- Copyrights - $30,000
- Patents - $20,000
Liabilities & shareholder’s equity
Current liabilities = $100,000
- Accounts payable = $40,000
- Wages payable = $30,000
- Taxes payable = $20,000
- Interest payable = $10,000
Long-term liabilities = $150,000
- Debentures = $100,000
- Mortgage bonds = $50,000
Stockholder’s equity = $275,000
- Preferred stock = $80,000
- Common stock = $150,000
- Capital in excess of par = $25,000
- Retained earnings = $20,000
Even though there are more categories, the idea stays the same: assets and liabilities are listed, and the difference ultimately ties to the owners’ claim on the business.
There are a few specific balance sheet items to know:
Current assets and liabilities
The term “current” means “short term.”
- Current assets are already cash or can reasonably be converted to cash within one year. These typically include cash, cash equivalents (like a money market fund), accounts receivable (money owed to the company within one year), and inventory.
- Current liabilities are due now or must be paid within one year. These often include items with the word payable in the name. Payable means the company owes a payment in the near term.
Fixed assets
These are long-term tangible assets. They typically include real estate, property, vehicles, and equipment.
Intangible assets
These are long-term non-physical assets. They typically include trademarks, patents, copyrights, and other forms of intellectual property.
Long-term liabilities
These are obligations that extend beyond one year. They typically include longer-term loans, bonds, and mortgages.
Stockholder’s equity
Equity relates to ownership. Stockholder’s equity typically includes outstanding stock, capital in excess of par, and retained earnings.
- Capital in excess of par is the amount investors pay above the stock’s par value. For example, if an issuer sells $100 par preferred stock for $102 per share, the company credits $2 per share to capital in excess of par.
- Retained earnings are earnings the company keeps rather than distributing to stockholders. If a company earns $100,000 and distributes $80,000 to common and preferred stockholders, it credits $20,000 to retained earnings.
Balance sheets ultimately show net worth, also called stockholder’s equity, which helps estimate the overall value of a company. 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, then subtract liabilities from assets.
Balance sheet formulas
Several formulas use current assets and current liabilities to measure a company’s liquidity (its access to cash and near-cash resources).
Current assets and liabilities
Current assets typically include cash, cash equivalents (like money markets), accounts receivable, and inventory. Accounts receivable are payments the company expects to receive soon for goods or services already provided. In other words, if the company has cash (or something that can reasonably be turned into cash within a year), it’s usually a current asset. From the earlier example:
Current assets = $125,000
- Cash and cash equivalents - $100,000
- Accounts receivable - $15,000
- Inventory - $10,000
Current liabilities typically include accounts payable, wages payable, taxes payable, and interest payable. These are bills the company must pay in the near term. They can relate to:
- The cost of goods
- Operating costs (general business costs)
- Interest costs on outstanding loans (including bonds)
- Taxes
If an obligation must be paid within a year, it’s generally a current liability. From the earlier example:
Current liabilities = $100,000
- Accounts payable = $40,000
- Wages payable = $30,000
- Taxes payable = $20,000
- Interest payable = $10,000
Current ratio
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: if a large bill showed up unexpectedly, could you pay it with what you have available in the near term? A company asks the same question.
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.
- If the current ratio is above 1, the company has more short-term assets than short-term liabilities.
- If the current ratio is below 1, the company does not have enough short-term assets to cover its short-term liabilities.
Net working capital
Another measure using current assets and current liabilities is net working capital. Instead of a ratio, it gives a dollar amount of net short-term resources.
Using the same numbers as above, can you calculate net working capital?
This result is a tangible number. In this example, the company has $25,000 of short-term assets available (after covering short-term liabilities) to help handle an unexpected obligation.
Quick formulas
The term “quick” refers to short-term finances. Each quick formula in this section measures liquidity. The more liquid a company is, the more cash and marketable assets it has available when an unexpected payout is due.
First, the quick assets formula:
This removes inventory and focuses on cash and other marketable assets. If a company needs to make a sudden payment, inventory may not be helpful right away (unless it can be sold quickly).
Next is the quick ratio, also called the acid test ratio. This is one of the best ways to measure liquidity because it compares quick assets to short-term obligations.
In general:
- A higher quick (acid test) ratio suggests greater liquidity.
- If the ratio is above 1, the company has enough short-term assets (excluding inventory) to pay its short-term liabilities.
- If the ratio is below 1, the company may need to sell inventory to meet short-term obligations.
Income statements
Now let’s look at an income statement. If you’ve ever reviewed your bank account activity, you’ve seen a personal version of this idea. Income statements focus on money coming in and money going out. For example:
| Event | Amount |
|---|---|
| Paycheck from job | $3,000 |
| Groceries | -$100 |
| Mortgage payment | -$1,500 |
| Total | +$1,400 |
This simple personal income statement shows that after these three events, the person has $1,400 of positive cash flow.
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 (revenue)
- Controls its costs (expenses)
Here’s a simplified corporate 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
Income statements summarize cash inflows and outflows over a period of time. In the example above, the company sold $200,000 of product and ended with $55,000 in net income after paying for inventory, operating expenses, interest, and taxes. It then paid $20,000 in dividends, leaving $35,000 as retained earnings.
As with the balance sheet, the exam focus is usually on understanding what the line items represent, not memorizing every detail.
Financial statements don’t always explain why a number changed. If a company reports a sharp increase in cost of goods sold compared with prior periods, there may be a legitimate reason (for example, a global pandemic requiring additional safety measures). When extra explanation 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.
Income statement formulas
One important formula uses earnings (profits) to help evaluate the value of a company’s stock.
PE Ratio
The price to earnings (PE) ratio is used by investors to judge whether a stock may be overvalued or undervalued.
- Price refers to the stock’s market price per share.
- Earnings refers to earnings on a per-share basis (earnings per share). Earnings come from the corporate income statement.
In general, a higher PE ratio suggests the stock may be more expensive relative to its earnings. For example, if the PE ratio is 100, the market price is 100 times the company’s annual earnings per share. Unless the company grows considerably, the stock may be overpriced. On average, PE ratios range between 15-25, depending on the company and industry.
Growth companies typically have higher PE ratios. These companies are expanding and are expected to generate larger profits in the future. As a result, the stock may look “overpriced” today, but investors may be paying for expected future 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.