Fundamental Analysis - Tools and Tactics

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Fundamental Analysis:
Tools and Tactics
Fundamental analysts use a number of tools to evaluate and measure
stocks. After all, before you buy a stock, you want to be sure that the
company is of good quality and that it is a good value at the price.
Investors who primarily use fundamental analysis to choose stocks typ-
ically use a variety of tools to decide which stocks to pick. In this sec-
tion, I briefly describe some of the most popular.
Income Statement: Learning How
a Company Makes Money
One of the best ways to determine how much money a company is mak-
ing is by looking at its income statement. This contains a lot of useful
information, such as the company’s sales, operating expenses, and
earnings. Figure 10-1 gives the income statement for Florida Star.
The top line of the income statement gives the company’s sales or
revenue (also referred to as the top line). Look to see if the company’s
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revenue is increasing when compared to that in earlier years. For exam-
ple, if you are a growth investor, look for companies whose revenue is
increasing by 15 percent or more each year.
The next section of the income statement gives operating expenses.
These are the costs of doing business, such as salaries, advertising,
training employees, and buying new computers, to name a few. There is
usually also a line for research and development (R&D), which is the
cost of developing and investing in new products.
The next three sections of the income statement describe the com-
pany’s income. Have you heard someone say, “What is the bottom

line?” This refers to a company’s net income (which happens to be on
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Florida Star Consolidated Income Statement
(in thousands)
2002 2001 2000
SALES REVENUES
Net Sales 2,895 2,682 1,654
Services 1,764 1,456 789
Hardware 1,591 1,101 961
Software 897 763 690
—————— —————— ——————
Total Sales Revenue: 7,147 6,002 4,094
OPERATING EXPENSES
Cost of sales 2,324 2,643 1,477
Advertising and promotion 987 877 654
Research and Development 104 91 58
Other operating expenses 78 65 29
—————— —————— ——————
Total Operating Expenses: 3,493 3,676 2,218
Earnings before income tax: 3,654 2,326 1,876
Provision for income tax: 78 67 43
—————— —————— ——————
Net Income: 3,576 2,259 1,833
EARNINGS PER SHARE
Earnings per share
of common stock .99 .87 .76

Figure 10-1
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the bottom line of the income statement). After paying all expenses,
how much money did the company make? This is net income.
Earnings per Share: Determining How Much Money
the Company Makes
No matter how good you think a corporation is or how much you love its
managers, if the company isn’t earning money, eventually its stock price
will fall. That’s where EPS comes in. You can find it at the bottom of the
company’s income statement, below net income. (You calculate EPS by
dividing a company’s after-tax profit by the company’s outstanding
shares.) You can also find the EPS in the company’s quarterly or annual
report, on any number of financial Web sites, such as Yahoo! Finance, or
in periodicals like Barron’s, the Financial Times, or the Wall Street Jour-
nal. The financial newspaper Investor’s Business Daily also ranks the
relative strength of EPS on a scale of 1 to 99. Figure 10-2 gives the EPS
for IBM.
If a company is earning more money, it obviously should be
rewarded with a higher stock price. That’s why it’s so useful to compare
the company’s earnings with those of the previous quarter or the previous
year to determine if earnings are going up. (Because some companies are
FUNDAMENTAL ANALYSIS
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Earnings Per Share: IBM
Earnings Per Share ($) for Fiscal Year Ending December
2002 2001 2000 1999 1998 1997
1Q 0.68 0.98 0.83 0.77 0.53 0.59
2Q 0.03 1.15 1.06 1.28 0.75 0.73

3Q 0.76 0.90 1.08 0.93 0.78 0.69
4Q 0.59 1.33 1.48 1.12 1.23 1.05
Year 2.06 4.35 4.44 4.12 3.28 3.00
Figure 10-2
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seasonal, quarter-to-quarter comparisons may not be as useful as year-to-
year comparisons.)
Unfortunately, finding out how much a company really earns is not
as easy as it appears. Some CEOs will play a number of accounting tricks
to make it appear that earnings are stronger than they really are. (To keep
stock prices artificially high, some CEOs “cooked the books,” or
changed the numbers so it appeared that the company was making more
money than it had in the past. In such cases, when the truth comes out, the
company is often forced to restate its earnings, causing the stock to plum-
met. For example, WorldCom restated its earnings by billions of dollars.)
It’s not enough to buy stocks in companies that grow by more than
15 percent a year—you must also understand how the company makes
that money. It sometimes takes a stock detective to find out the truth.
The Earnings Estimates Game
Adding to the confusion about EPS, stock analysts (people who are
paid to independently research corporations and make buy or sell rec-
ommendations on their stocks) make estimates or predictions of com-
panies’ future earnings. Often, a stock will rise on the expectation that
the company’s earnings will grow in the future. If a company beats ana-
lysts’ estimates, the stock price usually goes up. If a company misses
analysts’ estimates, even by as little as a penny, the stock price usually
falls. Sometimes a company will beat analysts’ published estimates but
not beat the “whisper number,” an unofficial earnings estimate that is
generally not made public. As noted earlier, CEOs are under extreme
pressure to beat the earnings estimates.

Looking at Stock Ratios
The Price/Earnings Ratio: The Granddaddy of Stock Ratios
Many people use the price/earnings ratio (P/E) to get a quick indica-
tion of whether the stock price is reasonable given the company’s earn-
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ings. When you divide the stock price by the company’s earnings per
share, you end up with a P/E ratio (also known as the multiple), that
can help you determine whether a stock is fairly valued. Many people
think that the P/E is the most effective way to measure a stock. Actu-
ally, the P/E is just one of many tools you can use to decide what
stocks to buy.
For example, a stock that sells for $20 a share and earned $2 last
year has a trailing P/E of 10 ($20 divided by $2); the trailing P/E uses
earnings from the last year. If a $20 stock were expected to earn $4 next
year, it would have a forward P/E of 5 ($20 divided by $4). In this case,
you are using analysts’ estimates concerning what will happen in the
future. The great thing about the P/E is that you can easily and quickly
compare individual stocks with one another, with their sector, or with
the overall market.
Many investors decide whether to buy a stock based on its P/E. For
example, value investors (bargain hunters looking for stocks of high-
quality companies that are selling for a reasonable price) prefer to buy
stocks with low P/Es, ideally under 15. (Warren Buffett, for example,
buys only companies with trailing P/Es of 10 or less.) On the other
hand, growth investors (aggressive buyers looking for stocks in compa-

nies whose sales or earnings are growing rapidly) don’t mind buying
stocks with high P/Es because they expect the companies’ earnings to
improve in the future. If a stock has a P/E of 50 but is growing by 60
percent a year, the stock could be a bargain.
Nevertheless, basing your stock decisions on what a company’s
earnings might be in the future has backfired on many investors. In par-
ticular, analysts’ expectations concerning future earnings have often
been overly optimistic. For example, in the late 1990s, analyst Mary
Meeker continually urged investors to buy shares of Priceline, even
though its P/E was outrageously high (it had no earnings and an
extremely high stock price). She claimed that traditional fundamental
measurements like P/E didn’t matter anymore. That was a few months
before Priceline fell from hundreds of dollars per share to a couple of
dollars. The lesson: P/Es do matter.
Even now, misconceptions about the P/E are common. Just because
a stock’s P/E is low doesn’t mean that you should buy the stock. And
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