You face two problems with fundamental analysis. First, abuses of the past show that you cannot rely on financial statements, even with the "independent" audit. Second, GAAP rules allow great latitude for companies in how they report.
The solution is to use three fundamentals that cannot be hidden or manipulated. All depend on analysis of a trend over several years and not on one-year ratios. These are:
1. Dividend growth. Seek companies that have increased their dividend every year for at least ten years ("dividend achievers"). A company must have funds available to pay dividends, so this is a great sign of sound management. Stocks of these companies also tend to be less volatile than average, and to grow over time.
2. Many years of growth in revenues and net profits. Check long-term growth in revenue dollars along with net return. If net return slips while revenues rise, is indicates diminishing control. As long as net return remains at the same percentage over five to 10 years, management is doing its job. It is impossible to manipulate these outcomes for more than a year or two.
3. A two-part test of working capital. You might believe that the current ratio is all you need to test working capital. This traditional test (comparing current assets to current liabilities) is valuable, but it is only part of the story. Check the debt ratio too. This is the percentage of long-term debt to total capitalization ("total" means equity plus long-term debt). The percentage should be holding steady or declining. Whenever you see the debt ratio increasing over the years, that is a danger signal - even if current ratio stays the same. It could mean that management is using part of long-term debt to keep in cash just to keep the current ratio looking healthy.
To show why you need all three tests, consider the case of Sears Holding (NASDAQ:SHLD). In each of the last four years going back to 2009, revenues and net income were inconsistent:
In Millions of dollars
Year Revenue Net Income net return
2012 $41,567 $ -3,113 - 7.5%
2011 43,326 150 0.3
2010 44,043 235 0.5
2009 46,770 53 0.1
Revenues fell erratically each year and net return provided no reliable trend. Even with these net losses, the current ratio remained between 1 and 2 for every year going back four years. How is that possible? Compare current ratio to debt ratio for four years:
Year Ratio Ratio
2012 1.1 27.3%
2011 1.3 22.6
2010 1,3 14.6
2009 1.3 10.8
By itself, current ratio looks great. When you also review debt ratio and see it moving upward from 10.8% to 27.3% over four years, the overall test is negative. This example demonstrates how to evaluate the fundamentals. A test of the long-term trend reveals the true strength or weakness of the company.
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