Fundamental Stock Research

If you want to buy individual stocks, there are several different techniques for identifying which ones to buy. I will first write about fundamental stock research. The goal of fundamental research is to gain an understanding of the profit dynamics of a company and to identify those companies that would make good investments. There is a difference between a good company and a good investment. A good company may be too expensive. That would give a much higher probability that the stock will go down or trade flat for an extended period of time than that the stock will go up in price. So, we want to identify good companies that will go up in price after we buy them as fast or faster than the broad stock market.

Stock analysts look at a company in at least three levels. They look at the company itself. They look at the company compared to others in its industry. They look at the industry compared to others in the economy. For the company, an analyst wants to answer the question, “Will the company generate sufficient cash flow to pay its debts, and have a return left for the share holders?” The analyst looks at several key financial ratios to help make this determination. The analyst would look at leverage, liquidity, earnings, and growth.

Leverage is a measure of how indebted the company is. Debt allows for faster growth. It also adds to the fixed expenses of the company because of the interest payments that have to be made. The analyst wants to ensure the company can pay the interest charges even in bad economic circumstances. Debt holders have priority over stock owners in bankruptcy, so leverage is important.

Liquidity is a measure of how much cash the firm has and how long it takes the company to convert other assets to cash. The company pays workers, suppliers, contractors and lenders with cash. If liquidity is not high enough, or if assets can’t be converted to cash quickly enough, the company might not be able to pay its bills during a bad economic time period.

The analyst wants to look at earnings. A company cannot survive for very long if it does not generate profits. The analyst wants to understand how variable the earnings are and what drives the variability. Profits in the financial statements can be manipulated to some extent. So analysts look at other measures that are less amenable to manipulation like cash flow. One ratio that is gaining adherents is Free Cash Flow. This measure is how much cash is left over for management to use after paying all the bills and after spending enough to maintain the company in its current condition (maintenance, replacement of plant and equipment.) Management can use Free Cash Flow for growth, to pay for additional debt, to distribute to stock owners, etc.

There are non-financial aspects of the company that are important as well. The analyst wants to understand what is the company’s competitive advantage. Is it technology, manufacturing efficiency, marketing, innovation, management or any other advantage? The analyst wants to pass judgment on the quality of management. Do they have a vision of where to take the company and do they have the skills to take the company towards that vision?

The analyst wants to understand the company within its industry. How is it the same and how is it different from other companies in the same industry. Will those differences make the company better or worse than its competitors? An analyst may build a composite financial statement for the industry by adding all the financials for the industry together and taking an average. Then the company could be compared to the average for the industry to identify financial differences.

The analyst also wants to understand how the industry is positioned in the economy. Is it cyclical with the economy, is it counter cyclical? Is it relatively unaffected by economic cycles? Is the industry growing as fast or faster than the overall economy? Is the industry growing or consolidating? Are there high barriers to entry to the industry or is it easy to enter competition?

All these questions help the analyst find good companies. The analyst then tries to establish a fair price for the stock. As mentioned previously, that may involve discounting some cash flow stream from future years back to the present to get a discounted present value. Dividing that amount by the number of shares outstanding give you a fair value for the stock. Because of uncertainty in the forecasts of future growth and earnings, the fair value may be expressed as a range of prices. If the stock is currently priced above the range, it is too expensive. If it is priced below the range, it may be inexpensive and may make a good investment. If it is in the range, it may be fairly priced, and may be a good candidate for a core holding in a beta portfolio.

When you read analysts reports, the best ones will cover all these subjects. Your public library is a good source for fundamental research. Many libraries carry Value Line. It covers a few thousand companies. Brokers also provide fundamental research. You can access much information at the Investors Relations section of most company’s web sites.

If you wish to do your own fundamental research, the best source for financial information I have found is from “Investor’s Alliance.” They are a not-for-profit firm in Florida dedicated to educating investors. They make 13 years of financial information available on companies that have been around that long for under $150 per year. They also provide stock prices updated daily. They have very powerful screening tools to help sift through all 9,000 plus publicly traded companies and all 7,000 plus mutual funds. They calculate all the standard ratios for you and give you the tools to calculate any other ratio you might want.

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