Doc Maher breaks things down for the TradeKing Community.
I evaluated companies for possible acquisition in my past employment. To do this I had to examine the company thoroughly. This included digging through a company's financial statements, analyzing their markets, market position, products, and management. This is a big job and it takes a lot of time and some specialized knowledge. Of course I had access to a lot of information that the average outsider would not.
While the average investor or trader probably doesn't have an MBA and the time to investigate every investment to that depth, being exposed to the type of things I looked at may help improve your results. There is a great amount of information available on the web for most public companies. In this series I will provide the tools to obtain that information and also understand how to interpret it. It will take a few posts to get through it all, but I have to start somewhere. Let's begin with the definition.
Using TradeKing's glossary, Fundamental Analysis is a method of security valuation which involves examining the company's financials and operations, especially sales, earnings, growth potential, assets, debt, management, products, and competition. Fundamental analysis takes into consideration only those variables that are directly related to the company itself, rather than the overall state of the market or technical analysis data.
Why do we care about security valuation? Whenever we make a trade, or buy or sell an investment, we are taking action based on our (or someone else's) evaluation or analysis of the investment's value. Another way to say that is we are making a judgment about the asset's price. Understanding fundamental analysis is another tool to help you make better decisions about how to manage your money.
When I was in Business School I remember the Economics Professor asking the class ‘what drives the price of a stock?' After some silence, the answer that we came up with was ‘earnings'. After all what are you buying when you buy a stock? You are buying a share in the company's earnings. The Professor continued: ‘OK, but companies only report earnings every three months so what drives the price day to day?' More silence. Finally we settled on this:
Stock price reflects the expectation of a company's future earnings discounted back to today.
Now that may be a bit of a mouth full but it gets right to the heart of the issue. Whether you're thinking short term or a long term this is what is driving the price of a stock. So let me pick this statement apart a little bit.
You will notice that earnings are still at the heart of the statement but that it now has a number of qualifiers. One of the first things you may notice is future earnings. While it is true that when we buy a stock we are buying a share of that company's earnings, we really don't care what the earnings have been in the past. We are not investing in yesterday. We are only concerned with what the earnings will be tomorrow. This explains why a company can beat its earnings expectations but still drop like a rock. Usually this happens when the Company gives poor guidance going forward. Yes - they had a great quarter, but their future earnings may not be so good. So as one would expect from the above statement the stock's price will be adversely affected. We have all seen this happen. Here is a recent example. On July 22 after the market closed, AAPL announced earnings per share (EPS) of $1.19. The analysts had estimated EPS of $1.08. Sounds like a good quarter, however the stock took a dive (chart below) with this BusinessWeek headline:
"Apple's Forecast Sets Off a Stock Slide. Despite boffo quarterly earnings and record Mac sales, Apple's announcement that margins will soon shrink had investors reeling"
Click here for a larger image.
So future earnings are the key. But we don't know what the future earnings are going to be. This is where the fun starts. Notice that my professor's statement says expectation. No one knows what the future will bring. Mark Twain is credited with saying: ‘this prediction business is very tricky, especially when it involves the future.'
So now we are left with trying to figure out the expectations of future earnings. Of course this changes from day to day depending on a wide variety of things. For instance if the economy is going to take a dive, then perhaps that will decrease discretionary spending and that might hurt the earnings of a company that is in the entertainment business. Apple might come out with a new product that will hurt RIMM's sales and that would be bad for RIMM's earnings. A mortgage company has a lot of risky debt on its books, we may be able to see how financially sound they are by looking through their financial statements.
The more you think about it the more things you can think of that may impact future earnings. The idea is that we can try to predict the future by using fundamental analysis. I will continue with that discussion next time.
There is one more thing in the statement that I wanted to discuss: discounted back to today. This may sound a little confusing but it's important. It has to do with when we the expect earnings will come. How much are you willing to pay today for earnings that will come in two years? I can't say exactly, but I know it's less than what we would pay for the same earnings next quarter. There are two reasons for this. First is the time value of money. Second is the additional risk that is associated with the increased uncertainty that a longer time frame brings. A lot can happen in two years that could change our expectations. So how much should we discount future earnings? Well like everything else, it depends.
Now that we have this foundation, I'll be working through how to analyze companies from a number of perspectives and where to find the information to do this. Please watch for my next post in this series.
"Income Trader"
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Doc's previous posts: Lehman, mortgage defaults, and the FED and Swing Trading GOOG Options
For a list of previous All-Star Trades, please click here.
Nicole Wachs contributed to this post.
Any strategies discussed and examples using actual securities and price data are for educational and illustrative purposes only and do not imply a recommendation or solicitation to buy or sell a particular security or to engage in any particular investment strategy. In reading content in the Community, you may gain ideas about when, where, and how to invest your money. Although you may discover new ideas or rationale that may be compelling, you must ultimately decide whether or not to put your own money at risk. Consider the following when making an investment decision: your financial and tax situation, your risk profile, and transaction costs.
Jonathan F. Maher, PhD has a professional business relationship with TradeKing.
