PinoyInvestor Academy - Fundamental Analysis Part 4

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FUNDAMENTAL ANALYSIS: PART 4

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INTRODUCTION TO FUNDAMENTAL ANALYSIS: PART 4 (by Investopedia.com and PinoyMoneyTalk.com)

In Part 3, we discussed the Quantitative factors involved in analyzing a stock

investment. We also took on the first two financial statements: the Income Statement and the

Balance Sheet. Here in Part 4, we’ll take a look at the third financial statement, the Cash

Flow Statement, as well as a primer on financial statement analysis and valuation.

The Cash Flow Statement

The cash flow statement shows how much cash comes in and goes out of the company

over the quarter or the year. At first glance, that sounds a lot like the income statement in

that it records financial performance over a specified period. But there is a big difference

between the two.

What distinguishes the two is accrual accounting, which is found on the income

statement. Accrual accounting requires companies to record revenues and expenses when

transactions occur, NOT when cash is exchanged.

At the same time, the income statement often includes non-cash revenues or expenses,

which the statement of cash flows does not include.



Just because the income statement shows net income of $10 does not means that cash on

the balance sheet will increase by $10. Whereas when the bottom of the cash flow statement

reads $10 net cash inflow, that's exactly what it means. The company has $10 more in cash

than at the end of the last financial period. You may want to think of net cash from operations

as the company's "true" cash profit.

Because it shows how much actual cash a company has generated, thestatement of cash

flows is critical to understanding a company's fundamentals. It shows how the company is

able to pay for its operations and future growth.

Indeed, one of the most

important features you should look

for in a potential investment is the

company's ability to produce cash.

Just because a company shows a

profit on the income statement

doesn't mean it cannot get into

trouble later because of insufficient

cash flows. A close examination of the

cash flow statement can give

investors a better sense of how the

company will fare.



Three Sections of the Cash Flow Statement

Companies produce and consume cash in different ways, so the cash flow statement is

divided into three sections: cash flows from operations, financing and investing. Basically, the

sections on operations and financing show how the company gets its cash, while the investing

section shows how the company spends its cash.

1. Cash Flows from Operating Activities

This section shows how much cash comes

from sales of the company's goods and

services, less the amount of cash needed to

make and sell those goods and services.

Investors tend to prefer companies that

produce a net positive cash flow from

operating activities.

High growth companies, such as technology

firms, tend to show negative cash flow from

operations in their formative years. At the

same time, changes in cash flow from

operations typically offer a preview of

changes in net future income. Normally it's a good sign when it goes up.



Watch out for a widening gap between a company's reported earnings and its cash

flow from operating activities. If net income is much higher than cash flow, the

company may be speeding or slowing its booking of income or costs.

2. Cash Flows from Investing Activities

This section largely reflects the amount of cash the company has spent on capital

expenditures, such as new equipment or anything else that needed to keep the

business going. It also includes acquisitions of other businesses and monetary

investments such as money market funds.

You want to see a company re-invest capital in its business by at least the rate of

depreciation expenses each year. If it doesn't re-invest, it might show artificially

high cash inflows in the current year which may not be sustainable.

3. Cash Flow From Financing Activities

This section describes the goings-on of cash associated with outside financing

activities. Typical sources of cash inflow would be cash raised by selling stock and

bonds or by bank borrowings. Likewise, paying back a bank loan would show up as a

use of cash flow, as would dividend payments and common stock repurchases.



Cash Flow Statement Considerations

Savvy investors are attracted to companies that produce plenty of free cash flow (FCF).

Free cash flow signals a company's ability to pay debt, pay dividends, buy back stock and

facilitate the growth of business.

Free cash flow, which is essentially the excess cash produced by the company, can be

returned to shareholders or invested in new growth opportunities without hurting the

existing operations. The most common method of calculating free cash flow is:

Ideally, investors would like to see that the company can pay for the investing figure out

of operations without having to rely on outside financing to do so. A company's ability to pay

for its own operations and growth signals to investors that it has very strong fundamentals.



Financial Ratio Analysis

The figures appearing on the company’s financial statements are not enough to present a

complete story of the overall financial performance of the business. To understand the

company’s financial health, the investor must conduct financial analysis and compare the

company’s financial ratios with standards, goals, or industry averages.

There are several types of financial statements analysis. Among them are analysis

related to breakeven point, profitability, liquidity, activity or asset efficiency, and debt or

leverage. These ratios are briefly summarized and explained below.

TABLE 1: BREAK-EVEN ANALYSIS

Financial Ratio Formula What It Means

Breakeven

Point

Fixed Costs

Contribution Margin per Unit

Important for young companies, this is

the point at which costs or expenses

and revenues are equal. At breakeven

point, the company has neither net

loss nor gain. Any units above the

breakeven point will generate a net

income for the business.

where:

Contribution Margin per Unit =

Revenue per Unit – Variable

Expenses per Unit



TABLE 2: PROFITABILITY ANALYSIS


Gross Margin ____Gross Profit __t

Net Revenues or Sales

Compares the company’s total sales

with the cost of those sales. An

increase in gross margin may result

from higher sales, lower cost of goods

sold, an increase in the proportionate

volume of higher margin products, or

any combination of the above. A

business with a higher Gross Margin

compared to a similar business

means it has higher profits that can

cover for other business expenses.

Net Profit

Margin

_____Net Income e

Net Revenues or Sales

The total profit per unit of sales after

all costs and expenses have been

deducted. A higher Net Profit Margin

means a company has better

profitability.

Return on

Equity (ROE)

______Net Income e

Average Stockholders’ Equity

The amount of net income returned

as a percentage of shareholders



equity. Return on equity measures a

corporation's profitability by

revealing how much profit a company

generates with the money

shareholders have invested.

DuPont Return

on Equity

(ROE)

Related to ROE,assets are measured

at their gross book value rather than

at net book value in order to produce

a higher ROE. If ROE is

unsatisfactory, the DuPont analysis

helps locate the part of the business

that is underperforming.It is also

known as "DuPont identity".

Return on

Assets (ROA)

___Net Income e

Average Assets

An indicator of how profitable a

company is relative to its total assets.

ROA shows how efficientlyassets are

being used to generate earnings.

Earnings per

Share (EPS)

___Net Income___s

Weighted Average Number of

Common Shares Outstanding

The amount of earnings per each

outstanding share of a company's

stock.



TABLE 3: LIQUIDITY ANALYSIS


Working

Capital

Current Assets – Current

Liabilities

An indicator of whether the company

will be able to meet its current

obligations. The greater the amount

of working capital, the more likely

the business will be able to make its

payments on time.

Current Ratio Current Assetss

Current Liabilities

Indicates the company's ability to pay

short-term liabilities with short-term

assets (cash, inventory, receivables).

A ratio under 1 suggests that the

company would be unable to pay off

its obligations if they came due at

that point. A 2:1 ratio is a standard

in most industries, although this is

not the case in all industries.

Quick Ratio Cash + A/R + Short-Term Investments

Current Liabilities

A more stringent ratio compared to

the Current Ratio, which excludes

inventory in testing the ability of the



company to pay short-term liabilities

with its highly-liquid assets.

TABLE 4: ACTIVITY OR EFFICIENCY ANALYSIS


Inventory

Turnover

Cost of Goods Sold

Average Inventory

Shows how many times a company's

inventory is sold and replaced over a

period. Must be compared against

industry averages. A low turnover

implies poor sales and, therefore,

excess inventory. A high ratio implies

either strong sales or ineffective

buying. High inventory levels are

unhealthy because they represent an

investment with a zero rate of return.

Days Sales in

Inventory

____365 days s

Inventory Turnover

The average number of days it takes

to sell the average inventory during

the year. Must be compared with the

industry average and the company’s

historical ratio.



Accounts

Receivable

Turnover

___Net Credit Sales s

Average Accounts Receivable

The number of times per year that

the accounts receivables are

converted to cash. A high ratio

implies that a company either

operates on a cash basis or its

extension of credit and collection of

accounts receivable is efficient. A low

ratio implies the need to re-assess

credit policies to ensure the timely

collection of imparted credit that is

not earning interest for the firm.

Days Sales in

Accounts

Receivables

___365 days s

A/R Turnover

The average number of days it takes

to collect the average amount of

accounts receivables during the year.

Compare with the industry average

and the company’s historical ratio.

Asset Turnover Net Sales

Total Assets

Measures a firm's efficiency at using

its assets in generating sales or

revenue. The higher the number, the

better.



TABLE 5: DEBT OR LEVERAGE ANALYSIS


Debt Ratio Total Liabilities

Total Assets

Shows what proportion of debt a

company has relative to its assets.

The ratio gives an idea to the

leverage of the company along with

the potential risks it faces in terms of

its debt.

Debt-to-Equity

Ratio

__Total Liabilities s

Stockholders’ Equity

Indicates what proportion of equity

and debt the company is using to

finance its assets. A high debt/equity

ratio generally means that a company

has been aggressive in financing

growth with debt. This can result in

volatile earnings as a result of the

additional interest expense.

Interest

Coverage Ratio

Earnings before Interest &Taxes

Interest Expense

Shows how easily a company can pay

interest on outstanding debt. The

lower the ratio, the more the

company is burdened by debt



expense. When a company's interest

coverage ratio is 1.5 or lower, its

ability to meet interest expenses may

be questionable.

A Brief Introduction to Valuation

While the concept behind discounted cash flow analysis is simple, its practical

application can be a different matter. The premise of the Discounted Cash Flow (DCF) method

is that the current value of a company is simply the present value of its future cash flows that

are attributable to shareholders. Its calculation is as follows:

For simplicity's sake, if we know that a company will generate $1 per share in cash flow

for shareholders every year into the future, we can calculate what this type of cash flow is



worth today. This value is then compared to the current value of the company to determine

whether the company is a good investment, based on it being undervalued or overvalued.

There are several different techniques within the discounted cash flow realm of

valuation, essentially differing on what type of cash flow is used in the analysis. The dividend

discount model focuses on the dividends the company pays to shareholders.The cash flow

model, however, looks at the cash that can be paid to shareholders after all expenses,

reinvestments, and debt repayments have been made.

Conceptually, they are all the same, as it is the present value of these streams that are

taken into consideration.

As we mentioned before, the difficulty lies in the implementation of the model as there

are a considerable amount of estimates and assumptions that go into the model. As you can

imagine, forecasting the revenue and expenses for a firm five or 10 years into the future can

be considerably difficult!

Ratio Valuation

On top of the financial ratios above, there are what we call valuation ratios.These help us

gain some understanding of the company’s value (i.e. whether it is undervalued or

overvalued).The most well-known of these are price-to-earnings and price-to-book. The latter

compares the company’s price per share to its book value.



The ratios are compared on an absolute basis, in which there are threshold values. For

example, in price-to-book, companies trading below '1' are generally considered undervalued.

Valuation ratios are also compared to the historical values of the ratio for the company, along

with comparisons to competitors and the overall market itself.

TABLE 6: RATIO VALUATION


Price-to-

Earnings

Stock Price

EPS

A ratio of a company's current share

price compared to its per-share

earnings.Also known as "price

multiple" or "earnings multiple"

because it shows how much investors

are willing to pay per dollar of the

company’s earnings. In general, a

high P/E suggests that investors are

expecting higher earnings growth in

the future compared to companies

with a lower P/E. Must be compared

with P/E ratios of other companies in

the same industry or against the

company's own historical P/E.



Price-to-Book

Stock Price s

Total Assets - Intangible assets -

Liabilities

Compares a stock's market value to

its book value. A lower ratio could

mean that the stock is undervalued.

However, it could also mean that

something is fundamentally wrong

with the company. As with most

ratios, this varies by industry. This

ratio also gives some idea of whether

you're paying too much for what

would be left if the company went

bankrupt immediately.

Credits: Investopedia.com and PinoyMoneyTalk.com

This wraps up the Introduction to Fundamental Analysis series of the PinoyInvestor Academy. We

hope Part 4 and its loaded information taught you how to use financial ratios so that ultimately, you

can make smarter investment decisions!



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PinoyInvestor Academy - Fundamental Analysis Part 4

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