There are seven fundamental factors that I always look at when performing research on stocks. Each one of these elements has been shown in academic papers as ways to outperform the general market averages. I will provide my opinions on the significance of each item.

1. Profitability

This is the most important signal, in my view. A company’s worth or stock price is directly related to how much profit it makes or will make in the future (i.e. growth). Sure, Revenue and Sales are important, but without profit a company has little worth, unless it has assets which can be sold for profit.

Example: Would you rather own a company with $10 Billion in sales that will perpetually lose money or have a $10 million company that has $1 million in profits.

My vote is for the latter, because a company that continues to lose money will eventually go out of business and no rational lender would continue to lend to a company that can not turn a profit.

Fat profit margins are a good sign.

2. Cash Flow

Cash flow tends to go hand-in-hand with profits. However, in some ways its even more important. Because of modern accounting standards, it is possible for profits/earnings to not result in any cash flow. Sales and profits can be recorded before the actual payment is received. 

Example: If you buy something with a credit card, the store can record the sale when you leave the store, but you don’t actually pay off the credit card until a month later. So, the store does not receive the “cash” until well after a month. In the meantime, the store knows how much it paid for the item and can record the sales and profits, but there is no cash flow from that item until the credit card transfers the money to the store.

So, in the short term, profits and cash flow can differ and its important to see if there is a positive or negative trend. Remember, 100% of all companies that fail do so because they run out of cash.

 

Cash flow from operations that exceeds earnings can often be a good sign.

 

3. Return On Invested Capital

I mentioned in signal #1 that the value of a company is directly related to profits and its growth. Return on invested Capital is a number that shows how much of a percentage return they are getting for their investments.

Example: A company that makes $8 million in profits expects higher sales in the next year so it invests $10 million in another plant. Here are two extreme scenarios…

 

Scenario 1: The company’s sales increase and the company now makes $10 million in profits, or $2 million more. The company’s return on its invested capital is 20%. This is good!

Scenario 2: The company’s sales decline instead of increase and profits drop $2 million, to $6 million. Now the return on invested capital is – 20%, which is very bad.

A company that has very good returns on investment capital is allocating its resources efficiently and insures that it can continue to grow profits.

Returns on invested capital that far exceed a company’s borrowing costs (or cost of capital) is a good sign.

4. Beating Estimates (plus whisper number)

Stock analysts who work at brokerage firms publish their estimates for company earnings (profits) per share, or EPS. The average EPS for a company by all the analysts that follow the company is called the consensus estimate. A company that exceeds this consensus tends to outperform the market. This is because the consensus is basically investor’s expectations of how much a company will make in profits per share. This ihas become somewhat of a game in that there is now something called a “whisper number” which is a number that people think a company will report but is unwilling to publish it.  Analysts have been accused in the past of keeping earnings low, making it easier for companies to beat their number. If there is a well known “whisper number” and the company doesn’t beat it, a stock could go down. Overall, companies that can regularly beat the consensus number or beat by a large amount is a good sign.

5. The Balance Sheet

The balance sheet tells us what the company has in assets and liabilities (often in the form of debt). We look at the balance sheet to make a general determination of its financial health. Usually, companies with little debt are healthier because they don’t have as many obligations and interest expense to pay off, which they then can then use these funds to re-invest in the company. Different types of companies can take on more or less debt.

Example: Steadier performing companies such as utility companies have a steady business and therefore have a greater confidence that it can earn back what it has borrowed.

Companies that can comfortably service its debt or have little debt is a good sign

6. Non Fundamental Signals (stock buybacks, increasing dividends, insider buying)

We’ve identified three positive catalysts for stock appreciation.

1) Stock Buybacks: This means the company is repurchasing its own stock. By doing this the company is increasing everybody’s share of the company by shrinking the pool of outstanding stock.

Example: There are 100 shares of stock outstanding and you own 10 shares. That is 10% of the stock. If the company repurchases 20 shares of total outstanding stock, you now own 10 shares out of a total of 80, or 12.5% of the company. That also means your share of the company’s profits are 12.5% greater, as well. This is a way for companies to re-invest in itself and return value to its shareholders.

2) Dividend Increase: This is very similar to stock buybacks, except instead of using cash to buy back stock, the company distributes the cash to its shareholders, allowing the individual to decide what to do with the cash. When a company increases its dividend, its often a good sign that they expect greater profits ahead too. Dividend payments tend to be fairly permanent (excluding this most recent recession), so management usually needs to be confident that they can pay it.

7. Value

Valuing a stock is by far the hardest thing to achieve in this business. All the previous mentioned factors can contribute to figuring out the relative or absolute value of a stock. 

Examples:

Many analysts use the P/E ratio or stock price divided by the earnings per share to determine if a stock is cheap or expensive, compared to how much money it makes. The lower the better, generally. The average stock market P/E is over long periods of time is about 15. However, companies that are in trouble are cheap for a reason. Still many studies have shown over time (5 years or more) that low P/E stocks tend to perform better than higher P/E stocks because if they don’t go out of business, they can rebound, and an investors often discounts its shares too much. In my view P/E ratios are a better determinant of how far a stock can fall, rather than how high it can climb.

Sometimes a company has great assets but little in the way of profits, sales or cash flow. For instance, a house has value but unless you rent it out, there are no sales or profits. Stocks can be similar. In my experience, I have on occasion found stocks that have been valued at or below the cash that the company had in the bank. If the business is viable and is likely to recover, this is often a sign that a stock is undervalued.

There is no exact science to finding the value of a stock. It is ultimately determined by what a buyer is willing to pay. When people are confident or more aggressive, they may pay more for the same stock simply based on emotion. An excess of this behavior often leads to bubbles in markets. The opposite can be true of stock values when there is great pessimism.

 Remember! Price is what you pay. Value is what you get.

 

 

Tags: cash flow, dividends, estimates, profitability, ROC