From the book "THE INTELLIGENT INVESTOR" written by Benjamin Graham: "Lynch’s rule—'You can outperform the experts if you use your edge by investing in companies or industries you already understand'—isn’t. totally implausible, and thousands of investors have profited from it over the years. But Lynch’s rule can work only if you follow its corollary as well: 'Finding the promising company is only the first step. The next step is doing the research.' To his credit, Lynch insists that no one should ever invest in a company, no matter how great its products or how crowded its parking lot, without studying its financial statements and estimating its business value.".
Fundamental analysis measures a security's intrinsic value by examining related economic and financial factors. Intrinsic value is the value of an investment based on the issuing company's financial situation and current market and economic conditions.
Fundamental analysis typically starts by analyzing a company's financial statements, including the income statement, balance sheet, and statement of cash flows. The information in these materials can be used to calculate and assess a company's financial health and intrinsic value. Key ratios derived from these financial statements include the Price-to-Earnings (P/E) ratio, Earnings Per Share (EPS), Return On Equity (ROE), and Debt-to-Equity (D/E) ratio, among others. Fundamental analysts use measures like these to determine whether a stock is undervalued or overvalued relative to its market price and competitors.
From the book "THE INTELLIGENT INVESTOR" written by Benjamin Graham: "It is clear that, at the least, a considerable momentum is attached to those companies that combine the virtues of great size, an excellent past record of earnings, the public’s expectation of continued earnings growth in the future, and strong market action over many past years. Even if the price may appear excessive by our quantitative standards the underlying market momentum may well carry such issues along more or less indefinitely.".
Benjamin Graham suggested seven quality and quantity criteria for selecting specific common stocks: 1. Adequate Size of the Enterprise; 2. A Sufficiently Strong Financial Condition; 3. Earnings Stability; 4. Dividend Record; 5. Earnings Growth; 6. Moderate Price/Earnings Ratio; 7. Moderate Ratio of Price to Assets.".
We will consider all the fundamental indicators and metrics described below in the financial analysis of our stocks. These are the indicators and metrics that will help us discover stocks with growth potential in the current quarter.
Only stocks whose all fundamental indicators and metrics have 'Normal' or 'Good' values will be considered eligible for trading.
VALUATION MEASURES
Large-cap: $10 billion or more.
Mid-cap: $2 billion to $10 billion.
Small-cap: $300 million to $2 billion.
Range: <2B:Bad; >=2B and <10B:Normal; >=10B:Good.
Used as a more comprehensive alternative to Market Capitalization. Measures the total value of a company.
Range: <2B:Bad; >=2B and <10B:Normal; >=10B:Good.
Trailing Price-to-Earnings (P/E)
A lower P/E ratio may indicate that the stock is undervalued.
A higher P/E ratio may indicate that the stock is overvalued.
Range: <15:Good; >=15 and <50:Normal; >=50:Bad.
Forward Price-to-Earnings (P/E)
A lower forward P/E ratio may indicate that the stock is undervalued.
A higher forward P/E ratio may indicate that the stock is overvalued.
Range: <15:Good; >=15 and <50:Normal; >=50:Bad.
Price/Earnings-to-Growth (PEG)
A PEG ratio lower than 1 are considered better, indicating a stock is relatively undervalued.
A PEG ratio greater than 1 are generally considered unfavorable, suggesting a stock is overvalued.
Range: <1:Good; >=1 and <2:Normal; >=2:Bad.
A P/S ratio less than 1 may indicate that the stock is undervalued.
A P/S ratio greater than 1 may indicate that the stock is overvalued.
Range: <1:Good; >=1 and <10:Normal; >=10:Bad.
A P/B ratio less than 1 signals to investors that a stock may be undervalued.
A P/B ratio greater than 1 means the stock is trading above its book value, which could imply overvaluation.
Range: <1:Good; >=1 and <5:Normal; >=5:Bad.
Enterprise-Value-to-Revenue Multiple (EV/R)
A EV/R multiple below 1 indicates that a company may be undervalued.
A EV/R multiple of 3 or greater would be considered quite high.
Range: <1:Good; >=1 and <3:Normal; >=3:Bad.
Enterprise Multiple (EV/EBITDA)
The lower the EV/EBITDA, the cheaper the valuation for a company.
A high EV/EBITDA could imply that the company is overvalued.
Range: <10:Good; >=10 and <25:Normal; >=25:Bad.
PROFITABILITY
A profit margin of less than 5% is relatively low.
A profit margin of 20% or more is considered very healthy.
Range: <0%:Bad; >=0% and <20%:Normal; >=20%:Good.
A operating profit margin of less than 5% is relatively low.
A operating profit margin of 25% or more is considered very healthy.
Range: <0%:Bad; >=0% and <25%:Normal; >=25%:Good.
A gross profit margin of over 50% is healthy for most businesses.
Range: <0%:Bad; >=0% and <50%:Normal; >=50%:Good.
MANAGEMENT EFFECTIVENESS
Range: <0%:Bad; >=0% and <15%:Normal; >=15%:Good.
Range: <0%:Bad; >=0% and <30%:Normal; >=30%:Good.
Range: <0%:Bad; >=0% and <25%:Normal; >=25%:Good.
INCOME STATEMENT
The total amount a business earns before any deductions for costs and expenses.
Range: <0:Bad; 0:Normal; >0:Good.
A negative gross profit means that the company is spending more on sales than it's earning in sales revenue.
Range: <0:Bad; 0:Normal; >0:Good.
It is a measure of a company's profitability, so the higher the EBITDA, generally the better.
Range: <0:Bad; 0:Normal; >0:Good.
A company with positive net income is more likely to have financial health than a company with negative net income.
Range: <0:Bad; 0:Normal; >0:Good.
BALANCE SHEET
A D/E ratio of less than 0.5 would be considered relatively safe.
A D/E ratio of 0.5 or higher may be considered risky.
Range: <0.1:Good; >=0.1 and <0.5:Normal; >=0.5:Bad.
Long -Term-Debt-to-Equity (D/E)
Range: <0.1:Good; >=0.1 and <0.5:Normal; >=0.5:Bad.
A current ratio of less than 1 may indicate that the company does not have capital available to meet its short-term obligations.
A current ratio greater than 1 indicates that the company has the financial resources to remain solvent in the short term.
Range: <1:Bad; >=1 and <3:Normal; >=3:Good.
Range: <1:Bad; >=1 and <3:Normal; >=3:Good.
CASH FLOW STATEMENT
Indicates whether a company can generate sufficient positive cash flow to maintain and grow its operations.
Range: <0:Bad; 0:Normal; >0:Good.
When free cash flow is positive, it indicates the company is generating more cash than is used to run the business.
Range: <0:Bad; 0:Normal; >0:Good.
A lower value for price to cash flow indicates that the company is undervalued and its stock is relatively cheap.
A higher value for price to cash flow indicates a company's stock is overvalued.
Range: <3:Good; >=3 and <50:Normal; >=50:Bad.
Range: <15:Good; >=15 and <50:Normal; >=50:Bad.
ANALYSIS
Measures the increase in a firm's sales from one quarter to another.
Range: <0%:Bad; >=0% and <25%:Normal; >=25%:Good
Stock markets tend to react in the same direction as earnings surprises - positively to positive earnings surprises and negatively to negative earnings surprises.
Range: <0%:Bad; 0%:Normal; >0%:Good.
A lower EPS may indicate that a company is struggling to generate profits.
A higher EPS may indicate a more profitable company.
Range: <0:Bad; 0:Normal; >0:Good.
Sales Growth Estimate (Curr. Qtr.)
Range: <0%:Bad; >=0% and <25%:Normal; >=25%:Good.
Sales Growth Estimate (Curr. Year)
Range: <0%:Bad; >=0% and <25%:Normal; >=25%:Good.
Growth Estimate (Curr. Qtr.)
Range: <0%:Bad; >=0% and <25%:Normal; >=25%:Good.
Growth Estimate (Curr. Year)
Range: <0%:Bad; >=0% and <25%:Normal; >=25%:Good.
HISTORY
A beta value of less than 1 means that the stock´s price is theoretically less volatile than the market.
If a stock has a beta value of 1, this indicates that its price activity is strongly correlated with the market.
A beta greater than 1 indicates that the stock's price is theoretically more volatile than the market.
Range: <1:Good; >=1 and <3:Normal; >=3:Bad.
Final Considerations
Although fundamental analysis helps us determine the value and growth potential of a stock, it is important to understand that there are other sources of information that can also help us better understand the evolution of the stock price. We should always use fundamental analysis in conjunction with technical analysis, as well as be informed daily about the recommendations given by research analysts, as all this information will help us make better decisions about the best time to trade stocks.
Sources:
- Fundamental Analysis: Principles, Types, and How to Use It, accessed 23 June 2024, <https://www.investopedia.com/terms/f/fundamentalanalysis.asp>
- Benjamin Graham, THE INTELLIGENT INVESTOR, Fourth Revised Edition, accessed 23 June 2024
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