Guide to fundamental stock analysis

Hi,

If you're reading this, you're probably either someone who wants to learn how to value stocks the way people on the Street do it, or you're someone who just wants to argue about academics/theoretical stuff. To the latter, sorry but I won't respond to those posts. To the former, welcome!

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Something like this...haha.

Introduction
First off, let me make this clear: Anyone can do fundamental stock analysis. It is just like learning a musical instrument or a programming language -- you just need to put in the time and hardwork to do it. Of course, it can take decades to become a master -- but you can get pretty good in a few years.

So what is fundamental analysis? It is the process of valuing a company by how much it earns. (As opposed to chartists who analyze market psychology by use of certain stock price movements and patterns)

A real life example: AT&T is set to earn about $2.25/share this year. If I buy 1 share for $28, I am essentially earning 8% on my investment. That's pretty decent. But if AT&T is trading at $22.50 for whatever reason, I would say to myself, "What a steal! It should be trading at a 8% return, or $28. But even if it stays at $22.50, I'm still making a 10% return." And that my friends, is one of the ways a fundamental analyst can think.

Fundamental analysis is the process of valuing a company by how much it earns.

Fundamental analysts use the following basic tools:
1 - Valuation by multiple
2 - Forecasting a company's earnings
3 - Forecasting a company's sales
4 - Understanding the risks

Valuation by multiple

Price to earnings ratio = Stock price / Earnings per share

This is by far the most common way to value stocks on the Street -- maybe 90%+ of price targets out there are based on this method. And it's very similar to the AT&T example I gave above.

AT&T is currently trading at $28 per share. Street consensus predicts AT&T will earn $2.50 in EPS (earnings per share) in 2011. This means if you buy AT&T today and its earnings stay flat, you'll get your invested money back in 11.3 years. So, in Street lingo, AT&T is trading at 11.3x FY11 EPS of $2.50.

This is the quick and dirty metric of how cheap or expensive a stock is.

Putting it into practice:
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This is AT&T's stock price chart, 1/1/10 to today. Doesn't it look expensive? It's trading at $28 today, vs. $26 back in April...the last time it was at $28 in January, it collapsed!

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This is AT&T's FY11 EPS multiple chart, same time period. Now you see that AT&T is trading at 11.3x today, but was also trading at 11.0x back in April! In reality, it's almost as cheap as it was back in April, and far cheaper than the 12.7x back in January.

+ Show Spoiler [Advanced concept: Earnings appreciation] +

What happened? Consensus FY11 EPS estimates were $2.36 back in April. But when AT&T reported better than expected subscriber numbers (thanks to the iPhone 4), everyone gradually raised their FY11 estimates to $2.50. Same multiple, but a slightly more profitable than expected company. This is why being able to accurately predict future earnings is key to fundamental analysis -- we'll cover this in the next 2 sections.

One more thing. When you value a stock based on a multiple, you need to factor in how "growthy" the stock is. For example, AT&T is a freaking huge and very old company, and its days of growth are long over -- its multiple is 11.3. The S&P 500 index is trading around 13.5x, a bit more expensive, which makes sense since your average company is growing a fair bit faster than AT&T. But Amazon, even as large as it is, is trading at a whopping 49x. This is because Amazon has been nearly doubling its sales and earnings every two years, and is likely to continue doing so even for the next few years.

+ Show Spoiler [Advanced concept: Valuing growth] +

So how do we value growth companies? One way is to estimate how much the company will earn once its growth returns to a more stable and normal level. For example, Amazon is trading at $168, which implies it will need to earn ~$12.50 in order to hit a 13.5x multiple. However, trying to estimate earnings more than 1 year out is notoriously difficult -- so the other and easier way is to simply look at other companies that have or once had a similar growth profile and simply compare multiples. For example, Ebay, another large e-commerce company that was still growing very quickly back in 2005-2006, was trading at 30x-45x in that time period. (Now it's trading ~16x, still a slight growth premium, but much closer to the S&P 500's 13.5x)

Valuation by earnings multiple is a quick and dirty way of measuring how cheap or expensive a stock is, calculated by how many years you would need to hold it to get back what you invested.

Forecasting a company's earnings
Valuation by multiple is almost always based upon a company's future earnings -- and the more accurately we can predict that, the bigger of an edge we have.

Earnings per share = Net Income / Diluted Shares Outstanding

Diluted shares outstanding is easy enough to get, you can look it up anywhere. But how is net income calculated? This one's a doozy:

Sales
- cost of goods sold
- operating expenses
- taxes
= net income

Putting it into practice:
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I actually never sold lemonade as a kid... in fact, all I did was play nintendo.

Let's say you hired a 13 yr-old to run a lemonade stand for you. The stand made $100 of sales in a day, but the cost of the cups, mix and water cost you $20. Then you paid the kid $40 ($5/hr), leaving you with $40 in profit. But now you gotta pay taxes of 25%, or $10, leaving you with $30 of net income.

Predicting operating expenses is easy enough -- employees wages are easy to forecast, as they increase at constant rates. Taxes don't change. And cost of goods is directly related to how much you sell, and in this example your cost of goods is 20% of sales (a.k.a. 80% gross margin). For the most part, we can assume cost of goods is fairly constant and predictable.

So really, once you figure out how much sales you'll make next year, you can quickly figure out what your net income will be. If you think your lemonade stand will make $40K next year, then you figure -8K from cost of goods, -10K from wages ($40/day * 250 days), -5.5K from taxes (25% of 22K pre-tax profit), that nets you 16.5K net income.

It's figuring out the sales part that's tricky.

+ Show Spoiler [Advanced concept: Gross margin pitfalls] +

Predicting gross margin is actually a fairly advanced concept, as sometimes a company's gross margin will abruptly change and its profitability completely erased.

For example, you're selling lemonade for $1/cup, the mix costs $0.20, that's 80% gross margin. But then a competitor comes along and undercuts you, selling for $0.50/cup. You have no choice but to match prices, and your gross margin falls to 40%. All of a sudden, you're losing money ($50 sales - $20 cost - $40 wages - $0 taxes = -$10 net loss).

Things like this happen very often with smaller companies that have first-mover advantage in new markets, as competition hasn't really come into play yet. And if your competitor is buying his mix for cheaper or paying his employees less, then you can bet he will undercut you to get all the customers.

I have seen this happen to several small tech companies that started out very successful, then competition comes in and eats half their gross margin. Suddenly they go from $2 in EPS to losing $2 in EPS, and their stocks plummet from $30 to $2.

In the end, only time and experience can truly help you judge these things. I'll cover this later in the last section, "Understanding risks".

+ Show Spoiler [Side note] +

Coincidentally, this explains why nearly all low-skill manufacturing jobs have moved to China. There is just no way we can compete, given their cost of labor is nearly non-existent compared to ours. The only exceptions are when the manufacturing is very high-skilled (i.e. Corning's glass, made in Kentucky) or if we have a technological cost advantage in making it (i.e. Rubicon's sapphire, made in Chicago).

Forecasting earnings is based on predicting sales, cost of sales, operating expenses, and taxes. The only truly difficult piece of the puzzle is the sales.

Well this took up a nice portion of my day. I'll continue the Forecasting sales and Understanding risks sections later. Hope this was easy to read and helpful -- feedback and questions welcome.

+ Show Spoiler [Disclosures/Disclaimers] +

Data used in this post is historical, and shouldn't be used to predict future values or prices. Any values shown are provided for information purposes only and are not guaranteed for accuracy or as realizable values.

I am not soliciting any action based upon this post. This post is not to be construed as a recommendation or an offer to buy or sell or the solicitation of an offer to buy or sell any security, financial product or instrument or to participate in any particular trading strategy.Although this material is based upon information that I consider reliable, I do not represent that this material is accurate, current or complete, and it should not be relied upon as such.

This post isn't a representation that any security described herein is suitable or appropriate for you. Investing in the stock market is inherently risky, and you should not enter into any transactions unless you have fully understood all such risks and has independently determined that such transactions are appropriate for you. Any discussion of risks contained herein with respect to any product should not be considered to be a disclosure of all risks or a complete discussion of the risks which are mentioned. You should not construe any of the material contained herein as business, financial, investment, hedging, trading, legal, regulatory, tax or accounting advice, and you should not act on any information in this service without consulting your independent business advisor, attorney, and tax and accounting advisors concerning any contemplated transactions.

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