Rookie Corner : The Foundation of Fundamentals : The Final Chapter!
Welcome to the show!
This week we are fitting all the pieces of fundamental analysis together! Here we are back again ready to bring all the concepts of fundamental analysis together into a usable skill set. We have talked about some widely used metrics for determining the value of a particular company versus that of another and we have gone over some lesser used models but that are no less important. In this weeks episode, we are going to discuss some of the issues that come with trying to determine value using fundamental analysis and we will also go over how we get around those particular issues.
So to review, the first week we went over P/E ratios, PEG ratios, Debt to Equity ratios and in the second week we looked the P/B ratios, the free cash flow, and the payout ratio. These numbers give us a picture of the overall health of a particular company versus a similar company. These are decent metrics for fundamental analysis and should be looked at, however, there are some challenges related to these numbers.
The first challenge is the PEG ratio. As we discussed, the PEG ratio takes into consideration the growth of a company. This is done by looking at past growth and estimating future growth. This is fraught with problems. First, just because a company grew at a certain rate in the past does that mean that it will continue to grow at that rate in the future? Will it grow slower or will it grow faster? It is very hard to know this so this is speculation at best. This doesn’t mean we don’t want to know this number and have it in mind when comparing companies, we just need to understand its limitations and we need to weight that in our decision making accordingly.
The second challenge is the Debt to Equity ratios. This is a good metric because it can give us signals that a company might be facing some future trouble if their earnings are not able to handle the debt load that the company is currently carrying. However, this is a metric where we need to dig a little deeper. Let me explain, if you have company A and it has a debt to equity ratio of 50 to 1 and you have company B has a debt to equity ratio of 25 to 1, and all other things being equal, is company B better than company A because they carry less debt? Not so fast, what if I told you that company A has used all that debt to buy other companies that could increase future earnings, or perhaps they use that debt to buy back shares which increases shareholder value and they did that because they were able to borrow that debt at ridiculously low interest rates? Would that change the tune of which company is better? It might? That is why we need to dig a little deeper into what the company has done with the capital that has been borrowed. We would need to look at the news resources and perhaps look at the investor page of the company website to see what kind of projects or takeovers they might be doing or have done?
The last thing we need to be cautious about is the numbers themselves. We need to remember that these numbers are self-reported and even though there are checks and balances within the system, sometimes creative accounting can get the best of companies that might be in trouble. If you remember the story about Enron and you looked at their financials then you would see that their numbers looked great, until they didn’t. Now, that doesn’t mean that every company is out there to deceive investors like Enron did, all this means is that we need to digest fundamental information the same way we digest all information, we need to use our common sense and logic filters to process the information. At the end of the day, fundamental analysis is just one tool in our toolbox that we use to help us find good companies to invest in.
Now that I have gone over the perils that can sometimes be present in fundamental analysis and we have gained an understanding that we need to filter this information with good common sense practices, is it possible that there is another way to make sure that we don’t get fooled by the perils that we spoke of? The answer to that is simply yes. Like everything else in life, there are many ways to accomplish the same things. This next part is what I feel is the best way to determine what the real deal is for any given company on any given day. It is the same way that law enforcement catches most white-collar criminals. When doing fundamental analysis we need to slap on our detective hats and follow the money! The metrics above give us a good look at companies but is it good enough? I think we can do better.
What if we looked at a company’s history to determine its possible future prospects? What if we looked at its current situation to see if the aforementioned future prospects were possible? This is what we need to really know to know if a company has long-lasting value. All of these things are tied to the money trail. First up is the dividend history of a company. Let me ask you this if a company was able to reward it’s shareholders with a consistent dividend every year for 50 years in a row, would it be reasonable that that same company may be able to continue to do the same? I would say that, that particular company is well positioned to continue to pay a strong dividend going forward, with the caveat that it isn’t always the case but probably true more often than not. A companies ability to pay consistent and increasing dividends over time shows that it has figured out to make profits on a pretty regular basis. This is a major sign of fundamental strength. This shows that this particular company can weather economic storms and still produce results. Think about what we have gone through in the last fifty years economic speaking, several market crashes, a couple of wars, the introduction of numerous new technologies and there are a number of companies that have paid regular dividends through it all and some have even increased their dividend for more years than I have been alive, and I wasn’t born yesterday folks. 🙂
Now the inevitable question always comes, well what happens if the company is struggling and they cut their dividend? Is there a way that we could possibly know ahead of time whether that might happen? The answer again is simply, yes. We have to go back to the money trail. If we look at the balance sheet and we see a company that is sitting on a mountain of cash and not holding too much debt then they are most likely positioned well to continue to pay dividends. This is also where we need to look at the payout ratio to see if it is sustainable long term. If the payout ratio is too aggressive that can be a sign of trouble, meaning that it would be hard to continue paying big dividends in times of trouble. Quality companies have a good dividend but not an outrageous one that couldn’t possibly be sustained long-term.
There is one more item fundamentally speaking that is of importance to know how a company may succeed in the future. This is fundamental based but is more intangible than that of the metrics we have discussed above. The last thing we want to know about finding a fundamentally strong company is what its product base looks like. If a company has recession-proof products then it will most likely be well positioned to survive the economic downturns that are inevitable. When I say recession proof products, I mean we have to ask ourselves if the economy takes a drastic turn down what would we still need to buy or what services would we still use? For example, do you still need to brush your teeth when times are bad? I would hope so. Would you still need the services of a bank when times are bad? You might not use them as much but I am still certain we need them because that is where all the money is kept. Would you still need fuel for your homes or your vehicles? I believe most folks would still require some of that aforementioned items. So as you can see from the questions above there are still things we have to have when times are tough and that means the companies that supply these things would still make some money in those troubled times.
We have gone through all the things I look for when evaluating a company based on its fundamentals. In next weeks video blog, I will walk through a real live example of how I research a company fundamentally and all the places I go to find to find the information to make solid fundamental decisions.
So keep your eyes on the skies and look out for my video message next week!
Invest well my friends!