Basic Fundamental Analysis of Stocks

Disclaimer: using fundamental analysis is a lot more intelligent than following hot stock tips or gambling on penny stocks. Even still, this article doesn’t present a full consideration of fundamental analysis and I’m not a pro. There’s no such thing as a sure thing.

I want to delve into the basic fundamental analysis of stocks with a minimum of preamble. But let’s get a few things straight:

• This article is about using fundamental analysis for value investing. It’s not my goal to fully define value investing (I might do a primer on it some day). Read Wikipedia or The Intelligent Investor (the definitive book on value investing). To oversimplify: value investing is about buying a stock that’s a good deal based on its sound fundamentals (e.g. business model, financials, etc.). It’s about buying for long-term dividends (the annual, quarterly, or monthly cash payments to each share’s owner). It’s not about seeking capital gains. That’s gambling, because prices are a random walk around a security’s true value. That true value already “prices in” information known to the market; thus, on average, you won’t “beat the street” with capital gains.
• This article isn’t about technical analysis, which is the antithesis of fundamental analysis (technical analysis is speculating in stocks based on historical price movements and a variety of imaginary indicators. It attempts to apply systemic analysis to the ‘random walk’ discussed above, but doesn’t withstand empirical analysis).
• I’m not advocating for stock picking (or, more aptly, stock selection). I’m not even advocating this particular system. The fundamental analysis presented in this article is extremely simple. It’s the quick and dirty version. Imagine that you have a half hour and you want to buy a stock. This isn’t how investing should be done. Full fundamental analysis requires that you delve into each stock’s financial statements. Surface level analysis (like I do in this article) is a recipe for disaster.
• Further to the last point, financial reports often include heavily fabricated numbers (you mean the government and Sarbanes-Oxley didn’t make everybody honest over night!?). Sure, financial statements present an image of the truth, but it’s an impressionist painting. Accounting rules have a ton of flexibility. Executives will report in a manner that reflects well upon their performance — i.e. their corporate reports are optimistic and the numbers are manipulated where it’s possible and legal.

The key to doing “quick and dirty” fundamental analysis is two-fold: use financial ratios and rely on technology to ‘sort’ the stocks for you. Here’s what I would do:

1. Use the Globe and Mail’s Stock Filter to get a shortlist of TSX-traded Canadian stocks. There’s also at least one other popular Canadian stock screener, but I prefer the G&M screener. To get my short list, I’d use the following three criteria:

• Dividend Yield (DY) of greater than 6%. I want to earn at least 6% on my invested capital; hence I only want to look at stocks that pay out a dividend of at least 6% of the price. If the DY ratio is really high (like 10%+) it probably means there was a huge dividend spike, e.g. a special dividend, or that the company’s prospects are bad (the price has dropped to reflect this, and the most recent dividend is therefore a larger percentage of the price). Then again, I currently own a stock that has a dividend of over 30% (CarFinco) because I bought it cheap. Keep open eyes and a skeptical mind.
• Price-to-Earning (P/E) ratio of less than 12. The P/E ratio establishes how many years it would take for the the company’s current net profit to cover the price. This kind of payback calculation isn’t empirically pure (the Gordon Growth Model is the truest method of stock valuation if you were wondering, but it’s not ideal for the real world). The higher the P/E, the worse the stock. Lower is better. Note that when you get into really low P/E ratios, e.g. below 4, there’s probably something bad going on. For example, earnings might have been boosted by a one-time event or the stock’s price may have plummeted to reflect a negative outlook.
• Price-to-Book (PB) ratio of less than 2. The ‘book value’ is the equity (the tangible assets less liabilities) of the company. It’s what the company would have if the company went out of business tomorrow (or, more correctly, what the investors would hypothetically get after creditors got their share). A lower price-to-book ratio, cateris paribus, means less risk because you’re paying less for the net tangible assets of the company.

Questrade is Canada’s best brokerage. 1 cent commission per share ($4.95 min, $9.95 max). $50 in free trades.

2. Cut out the risky stocks.

• Debt-to-Equity (D/E) ratio – I’d probably cut out any stocks with a D/E ratio of greater than 1. A lower number indicates stability — the company has more equity to cover debt. Keep in mind that setting a low D/E threshold could cut out entire asset classes or industries. For example: Real Estate Investment Trusts. Even the most stable REITs have debt; leverage is essential to their business models.
• Interest Coverage – this is the ratio of profit (except for taxes and interest) to the cost of interest on the company’s current debt. We’ve already covered long-term debt (in a way) with the D/E ratio (although it also includes current debt). More than the Current Ratio, the Interest Coverage ratio shows the business model’s sensitivity to its debt. The Current Ratio (and even more the Quick Ratio) just shows how much cash the company has to pay its current debts for the next year. You can infer things about a business model from the Current Ratio, but I think D/E and Interest Coverage give you a better picture.
• Dividend “Payout Ratio” (not to be confused with the DY) – this is the current dividend per share divided by the current earnings per share. Obviously, this number should be less than 100. If it’s higher, you know there’s a problem (a special dividend was recently announced, or perhaps the company is simply trying to pump-and-dump its stock). It shouldn’t even be close to 100, because dividends are cash but earnings are often ethereal (e.g. if the company invests all of its profit in a new plant, then it still made a profit for the year on paper but it couldn’t use the current year’s profit to actually pay any of the dividends). I’d like to see a Payout of under 80% and 90% would be an absolute cap. If this ratio is too low, then the company isn’t focused on rewarding shareholders which is, to me, problematic.

4. Briefly review the financial statements of the short-short listed stocks. I know that I said this was solely the ‘quick-and-dirty’ method of fundamental analysis. But I just can’t imagine not looking at the financial statements of companies in which I was considering investing.

• Income Statements - has revenue grown over the last three years or stagnated? Is an excessive growth in costs being masked by a growth in revenues? Are they undiversified in revenue (e.g. Google is entirely dependent on AdWords) or diversified (e.g. Berkshire Hathaway operates in every industry)?
• Cash Flow Statements – cash is king. And if cash is king, free cash flow is god. Free cash flow is the unencumbered cash that the company receives during a given period, after deducting all capital expenditures (e.g. investing in a new plant, like the earlier example). For dividends to be sustainable, they need to be paid out of free cash flow. Makes sense right? You’d be shocked by the shell game that a lot of companies play in order to pay dividends. I also like to see that a company is maintaining a reasonable cash buffer for its ongoing expenditures and possible emergencies, and that this buffer has been sustained over the last three years.

5. Choose which stocks to buy. The stocks I’d buy would be based on yield (the higher the better), my overall portfolio strategy (do I already have three bank stocks? Or do I need more financial sector stocks?), and the realities of my situation (how much do I have to invest at the moment?). Finally, my decision would be based on my current assessment of the market. On this point, I’d editorialize that there are currently fewer deals on the TSX than six months ago. “Sell in May and go away”? Perhaps. But the yields and P/Es still suck.

6. Execute the trades using Questrade. Questrade offers the lowest commissions and fees for Canadian stock trading, in my experience. You can do all the fundamental analysis you want, but if your cost structure is awful your returns will be sub-par. At the time of publication I am not a paid advertiser or affiliate for Questrade.

And that’s how I’d go about a “rush job” fundamental analysis for value investing in stocks.