Putting the Fundamentals Together

Before focusing on financial ratios, understand what the company actually does.

Ask basic questions such as:

• What products or services does the company provide?
• How does it generate revenue?
• Who are its customers?
• What industry does it operate in?
• What major costs are involved in operating the business?
• Does the business require substantial capital investment?

Financial statements become more meaningful when the investor understands the business behind the numbers.

One of the first questions in fundamental analysis is whether the company has demonstrated an ability to generate profits.

Earnings per share provides one way of examining profitability attributable to common shareholders.

Rather than relying on the most recent year alone, Stock Sage examines a five-year history.

Its core earnings requirement is:

Positive EPS in at least 4 of the previous 5 years

This allows for one unprofitable year while still requiring a recurring history of reported profitability.

Passing this requirement does not guarantee future earnings. It identifies a company that meets a defined historical profitability standard for further research.

Profitability alone does not describe a company's entire financial condition.

A company can report profits while also carrying substantial liabilities or experiencing deterioration in its balance sheet.

Stock Sage therefore applies a second core requirement:

Total Assets > Total Liabilities in each of the previous 5 years

This examines whether the company has consistently reported more assets than liabilities throughout the five-year period.

The requirement does not mean that the company has no debt or financial risk. It provides another historical financial screen.

Stock Sage's fundamental qualification process therefore begins with two historical questions:

• Earnings Test: Has the company reported positive EPS in at least four of the previous five years?
• Balance-Sheet Test: Have total assets exceeded total liabilities in each of the previous five years?

A company must satisfy both requirements to meet this core fundamental qualification.

These rules intentionally examine multiple years rather than allowing one recent result to determine whether the company qualifies.

After establishing an earnings history, investors can examine how those earnings are being produced.

Review:

• Revenue
• Gross profit
• Operating income
• Net income
• Earnings per share
• Profit margins

Ask whether revenue and earnings appear relatively consistent, improving, deteriorating, or unusually volatile.

A company can remain profitable while important parts of its income statement change significantly.

Profitability measurements can provide additional context about how efficiently the company converts revenue and capital into profit.

Measurements discussed in this course include:

Gross Profit Margin = Gross Profit ÷ Revenue × 100

Operating Margin = Operating Income ÷ Revenue × 100

Net Profit Margin = Net Income ÷ Revenue × 100

ROE = Net Income ÷ Average Shareholders' Equity × 100

ROIC = NOPAT ÷ Invested Capital × 100

These measurements answer different questions.

They should generally be interpreted in the context of the company's history, business model, industry, debt, and other financial information.

Next, consider how the company finances its operations and how significant its obligations are.

Research can include:

• Short-term debt
• Long-term debt
• Total liabilities
• Debt-to-equity
• Interest expense
• Interest coverage
• Debt maturities
• Current assets and current liabilities

Debt is not automatically a sign of financial weakness. The important issue is whether the company's obligations appear manageable relative to its assets, earnings, liquidity, and cash generation.

Reported earnings and cash generation are related but are not identical.

Review:

• Operating cash flow
• Investing cash flow
• Financing cash flow
• Capital expenditures
• Free cash flow

Free Cash Flow = Operating Cash Flow − Capital Expenditures

Comparing earnings with cash generation over several years can provide additional perspective on the quality and consistency of the company's financial results.

If the company pays a dividend, examine it in the context of the broader financial picture.

Consider:

• Dividend yield
• Dividend history
• Dividend growth
• Payout ratio
• Free cash flow
• Debt
• Other demands on company cash

A high dividend yield should not automatically be interpreted as attractive because a falling stock price can increase the calculated yield.

The more useful question is how the dividend fits with the company's earnings, cash generation, financial obligations, and capital needs.

If a company is repurchasing shares, examine whether the actual number of shares outstanding is declining.

An announced buyback authorization does not necessarily mean that the share count will fall.

Also compare buybacks with:

• Cash generation
• Debt
• Share issuance
• EPS growth
• The company's other uses of capital

If EPS is increasing while total company earnings are relatively unchanged, a declining share count may explain part of the increase.

A current financial number becomes more informative when placed beside its history.

Instead of asking only:

“What is the company's profit margin?”

“What has happened to the company's profit margin over the last several years?”

Apply the same approach to earnings, assets, liabilities, debt, cash flow, ROE, ROIC, dividends, and shares outstanding.

Trends can help reveal improvement, deterioration, stability, volatility, or a significant change in the company's historical pattern.

Fundamental research should not simply reward good numbers and reject bad ones without understanding them.

If one year looks significantly different from the others, investigate why.

Examples include:

• A year of negative earnings
• A sudden decline in profit margins
• A major increase in debt
• A large impairment charge
• A major acquisition
• An unusual increase or decrease in cash flow
• A substantial change in assets or liabilities

The unusual result may represent a temporary event, a structural change in the business, or something else entirely.

The financial statements identify the change. Research helps explain it.

A financially sound company and an attractively priced stock are not necessarily the same thing.

Fundamental analysis asks questions about the company.

Valuation asks questions about the price being paid for that company's earnings, assets, cash flow, or other financial characteristics.

A company can have strong historical fundamentals while its stock trades at a demanding valuation.

Likewise, a declining stock price does not automatically mean that a stock has become attractive.

This distinction is important because Stock Sage first evaluates defined fundamental characteristics and then provides price and valuation information for additional research.

A stock trading near its 52-week low is simply trading near the lower end of its price range over approximately the previous year.

That fact alone says nothing about the financial quality of the company.

A stock can fall because of temporary concerns, changing expectations, deteriorating fundamentals, industry conditions, company-specific problems, or many other reasons.

Stock Sage's research philosophy is therefore not simply:

“Find stocks near their 52-week lows.”

First identify companies that satisfy defined fundamental requirements, and then examine which of those companies are trading near their own 52-week lows.

This distinction is central to the Stock Sage research approach.

Price and value are different concepts.

A stock can decline substantially and still be expensive relative to its earnings or other financial characteristics.

Conversely, a company with a higher nominal share price can trade at a lower valuation relative to its fundamentals.

Investors should therefore avoid treating a low stock price, a large percentage decline, or proximity to a 52-week low as proof of undervaluation.

Valuation requires additional research.

A structured research process can help prevent one attractive number from dominating the analysis.

A simplified sequence is:

1. Step 1 — Understand the business

   Determine what the company does and how it makes money.

2. Step 2 — Review five-year EPS

   Determine whether the company has demonstrated recurring profitability.

3. Step 3 — Review five-year assets and liabilities

   Examine historical balance-sheet strength.

4. Step 4 — Review profitability

   Examine margins, ROE, ROIC, and earnings trends.

5. Step 5 — Review debt

   Consider leverage, interest obligations, liquidity, and debt trends.

6. Step 6 — Review cash flow

   Compare accounting earnings with operating and free cash flow.

7. Step 7 — Review capital allocation

   Examine dividends, buybacks, debt reduction, acquisitions, and reinvestment where relevant.

8. Step 8 — Examine price and valuation

   Determine how the current market price relates to the company's history and financial characteristics.

9. Step 9 — Investigate unusual results

   Research significant changes or inconsistencies before reaching conclusions.

This process is a research framework, not an automatic investment decision.

No individual measurement covered in this course provides a complete assessment of a company.

• A low P/E ratio can exist for a reason.
• A high ROE can be influenced by leverage.
• A high dividend yield can result from a falling stock price.
• EPS growth can be influenced by share repurchases.
• Positive net income does not necessarily equal strong free cash flow.
• Assets exceeding liabilities does not mean a company has no financial risk.

Each measurement provides information. The objective is to understand how the pieces fit together.

Stock Sage helps organize this research process.

Its core fundamental screening begins with:

Positive EPS in at least 4 of the previous 5 years

Total Assets > Total Liabilities in each of the previous 5 years

It can then provide additional financial and price information for researching companies that meet the applicable screening criteria.

The purpose of the software is to help users organize and evaluate financial information more efficiently. It does not eliminate the need for research or guarantee that a qualifying company will produce a particular investment result.

A screening result should not be confused with a prediction.

A company passing Stock Sage's fundamental requirements does not establish that:

• Its stock price will rise
• The company cannot experience future losses
• Its current valuation is attractive
• Its dividend will continue
• Its debt is insignificant
• Its business conditions cannot deteriorate
• It is appropriate for every investor

The screening process identifies companies meeting defined historical criteria. The investor can then perform additional research.

Once investors understand the financial condition of a company, the next major question becomes:

What price is the market asking investors to pay for those fundamentals?

That question leads to valuation.

Measures such as price-to-earnings ratios and historical valuation ranges can help investors examine the relationship between a company's market price and its financial performance.

This is why fundamental analysis and valuation are related but separate parts of the research process.

Completing this Fundamental Analysis course provides the foundation for the next Education topic: Understanding Valuation.