How to Use Basic Fundamental Analysis for Stock Picking

There are many schools of thought as to how an investor should intelligently choose the companies and stocks he will invest in. Some believe in fundamental analysis as the best way to go about this. Others rely on technical analysis of historical volume and price movements as represented by charts. Still, there are those who promote a combination of the two.

In this post, we’ll look at fundamental analysis as a basis for picking stocks.

Fundamental analysis basically means you look at the profitability of the business or the company represented by a stock which LOM does pretty well. You consider its past, current and projected performance in terms of earnings. You also try to understand the nature of the business – its customers and revenue sources, its competitors, its business processes, the management and owners, the company’s strengths and weaknesses, opportunities and threats, even macroeconomic and geopolitical / social factors that can affect it both the short and long term.

In a way, the fundamental investor, will take the viewpoint of someone buying into the business – as if he will actually be a owning a majority of the company. Someone in such a position would usually be investing for the long haul. Warren Buffet, for instance, is often quoted as saying that he buys a stock based on the assumption that the stock market will close the next day and not reopen for another five years. He also says that if you aren’t willing to hold a stock for ten years, you shouldn’t even think about owning it for ten minutes. If you want to follow Warren Buffet’s advice, then you need to do fundamental analysis on the stock you plan to buy.

Aside from long-term investors, value investors also need to apply fundamental analysis. The value investor believes that the market price does not always reflect a company’s true or intrinsic value. Market price frequently fluctuates – daily and even by the second at times. But the real value of the stock is relatively stable. So the value investor looks for price points where the market price falls far below the real value of a stock – and buys at such discount prices. He uses fundamental analysis to determine the real value – analyzing the financial statements published by a business quarterly and annually, also looking at financial projections based on revenue and cost data.

To do basic fundamental analysis you need the following Financial Statements, which are publicly available for all listed companies:

  1. Statement of Comprehensive Income or Income Statement
  2. Statement of Financial Position or Balance Sheet
  3. Statement of Changes in Equity
  4. Statement of Cash Flows

 

From these Financial Statements, you need to get the following data:

  1. Net Income (which can be found near the bottom part of the Income Statement)
  2. Revenue (which can be found near the top part of the Income Statement)
  3. Stockholders’ Equity (which is located near the bottom of the Statement of Changes in Equity)
  4. Outstanding Shares of Stock (which may be found in the Statement of Changes in Equity or in the Notes to the Financial Statements)

 

Equipped with the above data, you can then compute for the following financial ratios:

 

  1. Earnings per share (EPS) – compute this by dividing Net Income by Outstanding Shares of Stock. As a fundamental investor, you are concerned if the business is making money or not. So you look at the Net Income. By dividing Net Income by the number of outstanding shares, you convert the total Net Income figure on a per share basis. Thus you can compare different sized companies’ apples to apples just by comparing their EPS. The higher the EPS, the better.

 

  1. Profit margin– compute this by dividing Net Income by Revenue. Revenue is what a company gets paid for its products or services. Once you subtract from Revenue the costs that were incurred by the company, you get the Net Income. Profit margin shows how a company controls its costs. Assume two companies in the same industry. Company A has a net income of $1000. Company B has net income of $500. But then, Company had to earn revenues of $10,000 so it could earn the $1,000 net income. Meanwhile, Company B only needed revenues of $2000 to end up with the $500 net income. Company A has a profit margin of 10% while Company B has profit margin of 50%. Company B has better cost control and it is reflected in the higher profit margin. The higher the profit margin, the better.

 

 

  1. Return on equity (ROE)– compute this by dividing Net Income by Stockholders’ Equity. This ratio shows how effective a company is in generating profits using the capital it has. When comparing the ROE of two companies, the one with higher ROE made more profits out of the same capital invested or made the same profits out of less capital invested by the owners or stockholders. So the higher the ROE, the better.

 

  1. Price to earnings (P/E)– compute this by dividing the Market Price by Earnings Per Share. This ratio is used to compare companies within the same industry, especially since benchmark PE ratios differ from industry to industry. The higher the PE, the more expensive the stock. PE ratio basically means, how much an investor has to pay for the earnings of a share of stock. Comparing the PE ratio to the industry standard will help you determined if a stock is overvalued or undervalued.

Equipped with these simple ratios, you can already do basic fundamental analysis on any company you are considering for investment.

Miss Universe and Why Owning Up to Your Mistakes Can Make You a Better Investor

 

Beauty pageants don’t usually teach us some really heavy life lessons. But this year, at the 2015 Miss Universe Pageant, the audience witnessed something extraordinary that kept people talking about the event long after it was over.

Miss Universe has been running since 1952 as one of the most popular beauty pageants held internationally each year. Donald Trump used to co-own the Miss Universe Organization with NBC. However early this year, NBC boycotted the pageant after Donald Trump made some inflammatory statements about illegal aliens from Mexico. Trump bought the entire stock of Miss Universe Organization and later on sold it to WWE/IMG. Although not as popular in most western countries, the Miss Universe Pageant is a big affair for third world countries like Colombia and the Philippines.

So what was so special about this year’s Miss Universe? Well after the contestants were finally whittled down to two – Miss Colombia and Miss Philippines – the host, Steve Harvey, was supposed to finally announce the winner. But of all the horrible mistakes one can make, Steve Hervey, announced the wrong winner. So here was Miss Colombia, the Miss Universe sash and crown upon her, tears of joy streaming down her eyes, taking her first walk as Miss Universe 2015, waving to the crowd and the crowd going wild. In South America, the Colombians are already shouting on the rooftops, lighting fireworks and cheering for joy over their national victory.

Then, three minutes into all that, Steve Harvey goes back on the stage in Las Vegas and says to the entire audience that he made a terrible, terrible mistake. Miss Colombia was only the first runner up. Miss Philippines was actually the winner. The most awkward, unbelievable situation then befalls Miss Colombia. The crown had to be taken from her and transferred to Miss Philippines’ head. It was a live telecast via satellite so everything that went wrong was witnessed by the entire world, or should we say “universe.”

This is where the lesson comes in. Steve Harvey, as stupid as his mistake may have been, was a big man that night. It takes a big man to admit you’re wrong. And Steve Harvey did that in front of an arena, and the whole world for that, humiliating himself. When he admitted his mistake, he faced the possibility of ending his career, earning the ire of the world (particularly the Colombians), and hurting the feelings and embarrassing such a beautiful girl as Miss Colombia. He still did it though.

Are you like that when your investments go wrong? Different investors react in different ways when a stock they buy, for example, fails to perform as they expected. Some find it easier than others to admit that they made a mistake. The wise investors cut their losses ruthlessly, regardless of the initial pain. It hurts a lot when a paper loss becomes a realized loss. But after that, there’s also a feeling of relief and release. Release from worrying about your investment and wondering whether your loss will get even bigger. These investor types know how to accept the truth and move on.

Some investor types, however, can’t seem to sell their losing stocks. Some seem to be “in love” with their investment, thinking that they made the right analysis and chose the best – regardless of actual performance. They continue hoping that the price will rise in the end. Days turn into years and the investment stays stuck in their portfolio. These investors continue to deceive themselves and refuse to face the truth.

When Steve Harvey was going back up on stage to rectify his mistake, he seemed to walk around in a circle at first. He looked awfully nervous and hesitant, like he was trying to force himself to do something he found humiliating. But he still did it, however painful it was for him and everyone else. After he made the truth clear, and righted what he did wrong, there seemed to be an expression of relief that washed over his face. He got it over with. He did what he had to do.

Sensing that the audience was still confused and in shock, especially Miss Colombia and Miss Philippines, Steve Harvey even went further to tell the crowd that he was taking full responsibility for the awful thing that took place. That’s a brave man.

As investors, we also need to take full responsibility for our investment decisions. Don’t blame the underwriter or the research analyst or Vladimir Putin. Own up to your investment mistakes and learn from them. That’s the only way you can move on and shift to a better investment that might even help offset your losses. Win some, lose some. Cutting a loss means admitting you were wrong and owning up to your mistake.