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Experienced professional with expertise in financial statement analysis, value investing, and financial modeling. Past employment with the government (Internal Revenue Service), banking, insurance, and accounting service sectors. Licensed CPA with individual and corporate tax compliance... More
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  • Value Investing Fundamentals 4 comments
    Jul 21, 2014 11:03 AM

    Watching the World Cup Soccer Finals was exciting! Wouldn't you like to be a pro athlete in your favorite sport? The pros start off by practicing the fundamentals to play at such a high level. Like in sports, practicing the fundamentals are very important for value investing as well.

    How do you invest like Warren Buffett, Seth Klarman, or Howard Marks? You invest in good companies that are trading below their intrinsic value and wait until the stock realizes its fair value. This is true, but what does it mean to an average investor. How do you recognize a company is a good company when you are reading its financial statements? In this article, I will discuss: 1) some important Fundamental Analysis tools you can use to identify good companies and 2) the principles when to invest in their stocks.

    What is Fundamental Analysis?

    Fundamental Analysis involves analyzing a company's financial statements, business model, management, competitive advantages and its competitors along with its markets. There are many Fundamental Analysis tools out there, but I have chosen some of the most important ones to help you find good companies. To identify good healthy companies, you need to learn how to identify them thru Fundamental Analysis. The process of finding the best stocks "EVER" involves identifying the following:

    · Effective Profits

    · Valuations

    · Efficient Cash Conversion Cycle

    · Returns

    If you utilize the "EVER" process, you will be analyzing the health of a company's core business model by taking a temperature of its financial health.

    Effective Profits

    How do you measure if a company has Effective Profits? My answer is by looking at: 1) Sales Growth, 2) Earnings Growth, 3) Margins, and 4) Turnover.

    Sales Growth

    Growth of both Sales and Earnings are important when measuring the financial health of a company. Sales is a top of the line figure, while Earnings is a bottom line figure. What I mean is Sales is the first thing on an Income Statement then after expenses and taxes you arrive at Earnings.

    Analyzing Sales Growth is important and can be broken down into two components: 1) Price per unit of product/service increases and 2) Volume of unit sales increases (Sales = Price per Unit * Volume of Units). As a result, companies can be broken into four quadrants.

     

    Unit Price Increase

    Unit Price Decrease

    Unit Volume Increase

    1

    2

    Unit Volume Decrease

    3

    4

    Ideally, the good companies could be in quadrants 1, 2 or 3 as long as overall sales is growing. By evaluating how sales have grown, you can identify a company's pricing power and level of demand.

    In addition, you can break your Sales Growth analysis further by analyzing sales per location for a products business (i.e. average sales growth for each restaurant for McDonalds) or sales per employees for a service business (i.e. average sales growth for H&R Block).

    Earnings Growth

    Both Sales Growth and Earnings Growth are important and both should almost parallel each other in general (i.e. Sales Growth should translate to Earnings Growth while a decrease in Sales usually means Earnings decline also). Think of Sales and Earnings as the rails on a train track.

    A lot can happen from the topline Sales figure to the bottom line Earnings. Management use accounting rules and principles along with judgment in calculating expense and taxes. For example, they may use straight-line depreciation or decide to use a more aggressive double declining balance depreciation method. Other examples, they may choose not to expense an item, but capitalize it and deduct the expense over a number of years. What I am trying to point out is that JUDGMENT and sometimes manipulation are used to massage the final Earnings figures reported on the Income Statement.

    If Earnings Growth generally mirrors Sales Growth that is a good sign. In addition, Cash Flow per Share should usually be more than Earnings per Share and move in the same general direction. An exception to the Cash Flow per Share almost parallel Earning per Share rule of thumb is when a company is using its free cash flow to invest in expanding the growing business. For example, Starbucks invested free cash flow into opening new healthy stores and was earning good healthy profits and its Cash Flow per Share was less than its Earning per Share during that time.

    Analyzing Margins:

    Warren Buffett finds great healthy companies by looking at two factors (Margins and Turnover).

    • · Warren thinks that the best kind of business to own is one with high profit margins and high turnover.
    • · Warren believes the second-best kind of business to own is one with either high profit margins or a high turnover to compensate for lower profit margins.
    • · Warren is not interested in owning a business with both low profit margins and low turnover.

    ·

    Analyzing Effective Profits is also very important and can be broken down into two other components: 1) Margins and 2) Turnover. As a result, companies can also be broken into four quadrants.

     

    High Margins

    Low Margins

    High Turnover

    1

    2

    Low Turnover

    3

    4

    The best companies are in Quadrant 1 (the company is selling very profitable products/services AND a lot of them like Microsoft); the runner ups are in Quadrants 2 (the company is selling low profitable products/services, BUT a lot of them like Walmart) and 3 (the company is selling very profitable products/services, BUT not a lot of them like Rolex); and the companies to avoid are in Quadrant 4 (the company is selling low profitable products/services AND not a lot of them like a failed discount DVD store because people are now using Netflix and the internet for entertainment).

    There are three major margin ratios to consider: 1) Gross Margin, 2) Operating Margin, and 3) Net Profit Margin.

    Investopedia's definition of Gross Margin is: "A company's total sales revenue minus its cost of goods sold, divided by the total sales revenue, expressed as a percentage. The gross margin represents the percent of total sales revenue that the company retains after incurring the direct costs associated with producing the goods and services sold by a company. The higher the percentage, the more the company retains on each dollar of sales to service its other costs and obligations." A high Gross Margin means the company makes a high percentage of profit per unit sales. It is calculated as follow:

    Gross Margin = (Sales - Cost of Goods Sold) / Sales

    Investopedia's definition of Operating Margin is: "Operating margin is a measurement of what proportion of a company's revenue is left over after paying for variable costs of production such as wages, raw materials, etc. A healthy operating margin is required for a company to be able to pay for its fixed costs, such as interest on debt." Operating Income is Gross Income less Total Operating Expenses (i.e. Depreciation & Amortization, Research & Development Expenses, and Interest Expenses). It is calculated as follows:

    Operating Margin = Operating Income / Sales

    Investopedia's definition of Net Profit Margin is: "A ratio of profitability calculated as net income divided by revenues, or net profits divided by sales. It measures how much out of every dollar of sales a company actually keeps in earnings." It is calculated as follows:

    Net Profit Margin = Net Income / Sales

    The way you analyze the different margin ratios is by comparing the company's ratios to: 1) its major competitors, 2) its industry, and 3) its sector.

    Analyzing Turnover:

    There are three types of turnover ratios you should focus on: 1) Inventory Turnover for products companies, 2) Service Turnover for services companies, and 3) Asset Turnover for products or services companies.

    Inventory Turnover = Cost of Goods Sold / Average Inventory

    The Inventory Turnover ratio is a measure of the number of times inventory is sold or used in a time period such as a year. How you can utilize this ratio? You can compare the Inventory Turnover ratio for Target vs. Walmart and see the number of times inventory is sold over the year.

    Service Turnover = Sales / (Sales General and Administrative Expenses)

    The Service Turnover ratio is something I coined to measure the number of times services revenue is generated per Sales General and Administrative Expenses. A modification of the Service Turnover ratio would include Research & Development Expenses in the denominator. You can utilize this ratio to compare H&R Block vs Jackson Hewitt and see which company generates more sales per employee expenses.

    Asset Turnover = Sales / Total Assets

    The Asset Turnover ratio compares a company's sales to its total assets. This ratio gauges how well a business is making use of its total assets. The higher the multiple, the more efficient the company. Like all the turnover ratios, compare the company's ratios to: 1) its major competitors, 2) its industry, and 3) its sector.

    Efficient Cash Conversion Cycle

    You may have heard the phrase, "Cash is King!" How efficient is the company in generating cash from sales? How is it managing and collecting on its sales? How is the company managing its inventory? How good is the company at paying/financing its bills? These questions can be answered by analyzing how efficient is the Cash Conversion Cycle.

    CCC = # days between disbursing cash and collecting cash in connection with undertaking a discrete unit of operations.

    CCC for products companies = Days Sales Outstanding + Days Sales in Inventory - Days Payable Outstanding

    The Cash Conversion Cycle is a model that focuses on the length of time between when the company makes payments and when it receives cash inflows. A metric that expresses the length of time, in days, that it takes for a company to convert resource inputs into cash flows. The cash conversion cycle attempts to measure the amount of time each net input dollar is tied up in the production and sales process before it is converted into cash through sales to customers. This metric looks at the amount of time needed to sell inventory, the amount of time needed to collect receivables and the length of time the company is afforded to pay its bills without incurring penalties. Also known as "cash cycle."

    Days Sales Outstanding = Accounts Receivables Collection Period = Receivables / (Sales / 360)

    DSO is one of the key metrics for analyzing and identifying possible Revenue shenanigans. Days Sales Outstanding is the average length of time required to convert the firm's receivables into cash (to collect cash following a sale). A measure of the average number of days that a company takes to collect revenue after a sale has been made. A low DSO number means that it takes a company fewer days to collect its accounts receivable. A high DSO number shows that a company is selling its product to customers on credit and taking longer to collect money. For example, utilizing this ratio you may be able to spot Lucent booking sales but not collecting the revenue.

    Days Sales in Inventory = Inventory Conversion Period = Inventory / (Cost of Goods Sold / 360)

    DSI is one of the key metrics for analyzing and identifying possible Inventory shenanigans. Days Sales in Inventory is the average time required to convert materials into finished goods and then sell those goods. A financial measure of a company's performance that gives investors an idea of how long it takes a company to turn its inventory (including goods that are work in progress, if applicable) into sales. Generally, the lower (shorter) the DSI the better, but it is important to note that the average DSI varies from one industry to another. For example, this ratio would have help spot the growing inventory problems Coleco Industries had in the 1980's.

    Days Payable Outstanding = Payables Deferral Period = Payables / (Cost of Goods Sold / 360)

    DPO is one of the key metrics for analyzing and identifying possible Operating Expenses shenanigans. Days Payable Outstanding is the average length of time between purchases of materials and labor and the payment of cash for them. A company's average payable period. Days Payable Outstanding tells how long it takes a company to pay its invoices from trade creditors, such as suppliers. It isn't always negative if you see this ratio is increasing. For example, Home Depot delayed paying its suppliers and its DPO went from 21 days to 41 days. This move was justified because Home Depot's competitor (Lowe's) paid its suppliers in about 40 days at the time. By increasing DPO, Home Depot was able to free up more cash flows.

    An alternative for Days Sales in Inventory for service companies is something I coined Days Sales of Service. For products companies, you should utilizes DSI; however, for services companies you usually don't carry inventory.

    Days Sales of Service = Service Conversion Period = Sales / (Sales General and Administrative Expenses / 360)

    Days Sales of Service is the average time required to convert employee work expenses and then sell those services. A financial measure of a company's performance that gives investors an idea of how long it takes a company to turn its employee work expenses (including Research & Development expenses if applicable) into sales. Generally, the lower (shorter) the DSS the better, but it is important to note that the average DSS varies from one industry to another.

    CCC for services companies = Days Sales Outstanding + Days Sales of Service - Days Payable Outstanding

    Returns

    Please note that you should compare the company's return to its competitors, industry and sector when you are evaluating a company's returns. Each company operates in a different industry and sector. Therefore results across different industries and sectors carry different risks, returns and averages.

    Return on Equity:

    Return on Equity measures the efficiency with which a company uses shareholders' equity and is a great overall measure on returns on capital. (Note: A flaw in using ROE is a company can take on a lot of debt and boost ROE without becoming more profitable therefore you should look at Return on Invested Capital).

    ROE = Net Income / Shareholder's Equity

    Return on Assets:

    Return on Assets measures how much income a company generates per dollar of assets. Investopedia define ROA as follows: "An indicator of how profitable a company is relative to its total assets. ROA gives an idea as to how efficient management is at using its assets to generate earnings. Calculated by dividing a company's annual earnings by its total assets, ROA is displayed as a percentage. Sometimes this is referred to as 'return on investment'."

    ROA = Net Income / Total Assets

    Return on Invested Capital:

    Return on Invested Capital combines the best in both worlds by measuring the return on all capital invested in the firm (both debt and equity). Does the company show a consistently high return on total capital (above 12%)?

    ROIC = (Net Income - Dividends) / Total Capital

    Return on Capital:

    ROC = EBIT / (Net Working Capital + Net Fixed Assets)

    EBIT is used because companies operate with different levels of debt and differing tax rates. By using EBIT, you can compare the operating earnings of different companies without the distortions arising from differences in tax rates and debt levels.

    Net Working Capital + Net Fixed Assets (or tangible capital employed) was used in place of total assets (used in ROA) or equity (used in a ROE). Figures out how much capital is actually needed to conduct the company's business. Net Working Capital is used because a company has to fund receivables and inventory. Net Fixed Asset is used because a company has to fund the purchase of fixed assets to conduct business (i.e. real estate, plant and equipment).

    Return of Free Cash Flow per Sales:

    Free Cash Flow = Cash Flow from Operations - Capital Spending

    Return of Free Cash Flow per Sales = FCF / Sales

    Anything above 5% is doing a solid job at generating excess cash. Combining this ratio with ROE, you can divide companies into 4 categories.

     

    High ROE

    Low ROE

    FCF / Sales > 5%

    1

    2

    FCF / Sales <= 5%

    3

    4

    Companies in Quadrant 1 are likely Wide Economic Moat companies; companies in Quadrants 2 and 3 are less desirable; while companies in Quadrants 4 likely the least desirable companies.

    Valuations

    Value the Company

    Identifying good healthy companies is the first step by analyzing the Effective Profits, Efficient Cash Conversion Cycle, and Returns. The second step is determining if it is a good stock to invest. To determine if the company would be a good investment you need to value the company and compare your valuation of the company's worth to its current market value. One tool that helps you value a company is the Discounted Cash Flow method.

    Investopedia defines Discounted Cash Flow as follows: "A valuation method used to estimate the attractiveness of an investment opportunity. Discounted cash flow analysis uses future free cash flow projections and discounts them (most often using the weighted average cost of capital) to arrive at a present value, which is used to evaluate the potential for investment. If the value arrived at through DCF analysis is higher than the current cost of the investment, the opportunity may be a good one."

    The idea I want you to remember is that you need to value a company's intrinsic value. To do so, you can use the DCF method, Gordon Growth Model, Residual Income Model, Relative Valuations or other value investing methods available to arrive at the intrinsic value. Each model has its strengths and weaknesses. The skill is knowing how and when to use the various models.

    Buy with a Margin of Safety

    Investopedia defines Margin of Safety as: "A principle of investing in which an investor only purchases securities when the market price is significantly below its intrinsic value. In other words, when market price is significantly below your estimation of the intrinsic value, the difference is the margin of safety. This difference allows an investment to be made with minimal downside risk."

    Your valuation of the company may be approximately right. To cushion the downside risks and improve on your upside growth potential, you should buy with a Margin of Safety (buy below your intrinsic value of the company).

    Conclusion

    When you practice using these Fundamental Analysis tools, you can identify good healthy companies. It will help you find some of the best stocks "EVER". 1) You will be able to find companies that have Effective Profits. 2) You will buy companies with attractive Valuations. 3) You will understand how Efficient the Cash Conversion Cycle is. 4) You will identify companies with great Returns. Great companies have increasing sales, good returns and are both effective & efficient in its operations. Great stocks are great companies that sell below the intrinsic value and at a reasonable Margin of Safety.

    Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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Comments (4)
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  • somedata1
    , contributor
    Comments (568) | Send Message
     
    Very good write-up about fundamental analysis. What do you think about GILD,MU,V and MA?
    21 Jul, 11:36 AM Reply Like
  • Nelson Nguyen
    , contributor
    Comments (2) | Send Message
     
    Author’s reply » Thank you! I am not familiar with those stocks. However, you can focus on Returns (ROE, FCF/Sales, ROIC and ROC) that are above industry and sector averages. Then look for quality by focusing on both Effective Profits and Efficient Cash Conversion Cycle (Compare those results to its major competitors). Finally try to value the company. If you don't have time for an absolute intrinsic value (i.e. Discounted Cash Flow, Residual Income, Dividend Growth, etc.) then try a Relative Valuation.

     

    Check out this article on how to build a DCF Model:
    http://bit.ly/1yQZmWb

     

    Check out this article on Relative Valuation: http://bit.ly/1yQZl4g

     

    Good luck!
    21 Jul, 01:33 PM Reply Like
  • Nelson Nguyen
    , contributor
    Comments (2) | Send Message
     
    Author’s reply » Thanks for your comment! I am not familiar with those stocks. However, I would look at there Returns (ROE, FCF/Sales, ROIC and ROC) and compare their majors competitors, industry and sector. If they are good, then do a little further digging into the numbers to determine the quality by focusing on both Effective Profits and Efficient Cash Conversion Cycle. Finally, value the company by using an absolute valuation (Discounted Cash Flow, Residual Income, Dividend Growth, etc) or if you don't have time a Relative Valuation.

     

    Checkout this article on how to build a DCF Model:
    http://bit.ly/1yQZmWb

     

    Checkout this article on Relative Valuations:
    http://bit.ly/1yQZl4g
    21 Jul, 01:33 PM Reply Like
  • somedata1
    , contributor
    Comments (568) | Send Message
     
    Thank you. I'll try that. These are the top stocks I found in S&P 500 stocks. GILD, MA and V have net profit margin over 40%. MU is up > 150% from last year and it is still undervalued by looking at it's cashflow. I would argue GILD is the best growth idea of this century. MA and V are wonderful growth stocks. They are with very stable earning growth YOY although they are a little pricy right now. For the long term, they will beat most of the stocks in S&P 500.
    21 Jul, 01:42 PM Reply Like
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