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02/09/2011

Four Investing Fundamentals Everyone Needs


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4 Investing Fundamentals Everyone Needs The majority of investors—even those who swear they follow fundamental indicators—tend to act on and react to the market chaos seen in the daily action of the DJIA and stock prices. The short-term price movement in the market is always chaotic and, as confusing as this is, it can become your greatest advantage.

If you pick stocks based on the identification of four key fundamental indicators, you narrow down your list to the best companies. If you then time your entry on the price dips in the market, you can buy those companies at bargain prices. Two key rules should always be kept in mind. First, pick companies and stocks based on sound fundamental analysis. Second, time your purchase based on value and avoid relying on passing fads.

Fads come and go, including fads in which fundamental indicators are in favor at any given moment. The popularity of EBITDA (earnings before interest, taxes, depreciation, and amortization) is a good

example. Many years ago this calculation was all the rage because it approximated the company’s core earnings on a cash basis. It was flawed, however, because it did not adjust for situations with large intangibles on the books or for journal entry–based revenue adjustments. EBITDA also provided no “actionable intelligence” about companies or their stocks. The fad distinguished cash-based income only and did not identify long-term trends or growing revenue and earnings. This calculation has fallen out of favor more recently.

So if you believe in the fundamentals, but you don’t know how to narrow down the list of what to watch (or more to the point, how to interpret a long list of indicators) what guidelines are best followed? There are dozens of possible indicators, but many do not actually help you eliminate candidates or focus in on others, and that is what you need to make wise investment decisions. Consider the following four suggestions in selecting and applying fundamental indicators:

  1. Always strive for relevance. Some fundamental indicators can be tracked and followed with ease, but they do not provide anything of value in attempting to isolate companies worth buying. For example, one indicator compares sales to depreciation in an attempt to quantify equipment usage as a factor in generating sales. However, this ratio does not reveal much about basic value or long-term growth prospects. It is not relevant to the more immediate task of picking stocks. The indicators that work best directly show you financial strength or weakness compared to other companies.
  2. Do not rely on a single indicator without also looking at its trend over time. The majority of indicators evolves over time and should not be viewed for one period alone. A 10-year trend in an indicator is much more revealing than any single year outcome. One market adage advises that “the trend is your friend.” In fundamental analysis, this definitely is the case.
  3. When possible, combine two or more related indicators to evaluate a company’s performance. Financial analysis does not involve only a review of single-indicator outcomes or trends. Rather, it makes the most sense when several different indicators are taken as a whole to judge the financial health of a company and its prospects for future growth. For example, in checking working capital, most analysts like the current ratio. But this can be manipulated quite easily to look good at the end of the fiscal year. A smarter approach is to review both current ratio and debt ratio together to see what is really going on with working capital.
  4. Limit analysis to historical indicators and discount the value of estimates of future performance. The premise underlying fundamental analysis is that the reported results of a series of years set a pattern. These outcomes define success. Fundamental analysts believe that future growth can be anticipated and compared by relying on this historical record. With this in mind, it also makes sense to limit fundamental analysis to the historical record and to not use estimates of future change. A good example is a comparison between the historical price/earnings (P/E) ratio and the forward P/E. The latter is an indicator based on estimates of future earnings, so it is not as reliable as the known values in the historical P/E.

With these four suggestions in mind, the following sections describe the four key fundamental indicators that provide the most valuable insights to profitability, operations management, and cash flow control with an organization. These are revenue and earnings, the debt ratio, the P/E ratio, and dividend payment and history.

–Michael C. Thomsett. Excerpted from 4 Investing Fundamentals Everyone Needs (FT Press Delivers Insights for the Agile Investor).


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