Fundamental Analysis

There are two general schools of thought concerning how to pick stocks. Fundamental Analysis examines the basic nature of fundamental analysis, the examination and analysis of financial statements and related news and trends, and how the indicators found in the historical record are used to pick companies and then buy their stock.

The second approach is technical analysis, or the analysis of price and chart patterns to spot reversals in trends and to time the purchase or sale of stock.

Key Point

The most important diff erence between fundamental and technical is in the nature of data used.
Fundamentals focus on the published results of operations; technicals involve price patterns and changes.
On the fundamental side, the starting point of analysis of the most recent results of operations is found each year in the annual report. This not only summarizes the financial statements, but includes management's explanation of the financial record, markets, products, or services, and how the company plans to compete in the immediate future.

The annual report is available on the web site for a listed company. Most provide the report in either PDF or HTML format, or the report can be requested for delivery in hard copy. This is true for nearly all of the companies whose shares are traded publicly and owned by either institutional investors or retail investors.

The annual report is valuable because it includes extensive narrative sections explaining the significance of the numbers found in the financial statements. However, annual reports also have three major drawbacks for the purpose of performing in-depth analysis of trends:
  1. The statements and footnotes are very technical. It is not easy to understand many of the technical accounting explanations included in the footnotes, which at times run 100 pages or more. The complexity of the accounting narratives makes annual reports useful to only a few financial experts.
  2. The narrative explanations may be factual or marketing-related. It is not always easy to distinguish between factual interpretations of a company's results and the promotional spin management places on what may be a weak year or even a failed year. The management explanation is always upbeat and positive, making it difficult to determine how objectively the financial results are being interpreted.
  3. The annual report, in spite of its length, lacks detail. To properly analyze the fundamentals, you need as many years of results as possible. Annual reports may provide only three or five years' worth of selected financial results, and in some cases only the current year and the previous year. Additionally, most annual reports leave out key ratios and indicators, so that you have to study the details to create your own base for analysis.

Key Point

The annual report is a valuable source for information; but it also has limitations. You get much better information from free research services that summarize important indicators and give you many years' history.

The drawbacks in annual reports are best overcome by relying on a longer-term summary of not only the key financial results, but the important indicators as well. Most online brokerage services provide members with free analytical services. One of the best of these is the S&P Stock Report, which is available for over 5,000 listed companies. This is provided free of charge to subscribers of Charles Schwab & Co., TD Waterhouse, Scottrade, and e*Trade. The S&P Stock Reports contain a wealth of information for a 10-year period. This includes not only the key information you find in the financial statements, but other valuable information as well for 10 years, including:The core earnings deserve additional explanation. Under the rules accountants use, some nonrecurring transactions are allowed to be included in net earnings. However, Standard & Poor's developed a calculation to isolate the net profit from the company's 'core' or primary business. The differences between net income and core net income can be substantial, so this is a valuable additional form of fundamental information.

Key Point

Reported net income is not always the most accurate summary of what took place for the year. For that you need to track core earnings and to be aware of the changes between net and core -- the bigger the changes, the less accurate the traditional fundamental indicators.
Financial statements are prepared in a well-defined but archaic format. This means that much of the valuable information you need in order to track fundamental trends is simply not available from the latest published financial statements or annual reports. This is why you will find it more convenient to make use of services like the S&P Stock Reports for 10 years of history, rather than trying to master financial statements and how they work. However, it is also important for every fundamental investor to know what financial statements contain and what they reveal.
By Michael C. Thomsett
Michael Thomsett is a British-born American author who has written over 75 books covering investing, business and real estate topics.

Copyrighted 2020. Content published with author's permission.

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