The six fundamental indicators every investor must use

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1 The six fundamental indicators every investor must use

2 Definition Fundamental analysis the study of a company s capital value (on the balance sheet) and profit or loss (on the income statement) to determine its overall viability as an investment; to identify financial trends; and to decide whether the current price is reasonable based on trends in revenue and profit. Fundamental analysis includes the study of: the balance sheet, the value of assets, liabilities and net worth as of the end of the quarter or year. the income statement, a summary of revenues, costs, expenses and profits during a quarter or full year. other financial attributes including the earnings per share, competitive position within the industry, and dividend history.

3 The six indicators An investor may use any number of fundamental indicators, but six are essential for everyone. These are: 1. growth in revenues 2. growth in earnings 3. price/earnings ratio (P/E) 4. dividend yield 5. dividend growth 6. debt ratio

4 1. growth in revenues

5 The nature of revenue growth What should you expect to see? The trend and how it changes The tendency for trends to level out Revenues are tied to earnings Revenue dollar values should grow Earnings percentage should be consistent

6 Problems with revenue Revenues trend erratically Revenues grow while earnings do not Revenues remain level or begin to slide

7 2. growth in earnings

8 How earnings grow Net return should remain consistent or rise The net dollar value should grow as well Seek consistent earnings trends

9 Problems with earnings The net return declines even if dollar amount grows Revenues outpace the net return Revenues grow while earnings move to negative

10 Revenue and earnings examples You can only tell how a trend is evolving by studying a long term trend A 10 year trend is excellent because it reveals how trends move through time Track revenues and earnings together to get the full picture

11 General Mills (In millions). Revenue Earnings 2003 $10,506 $ ,070 1, ,244 1, ,640 1, ,442 1, ,652 1, ,691 1, ,797 1, ,880 1, ,658 1,567

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13 Caterpillar (In millions). Revenue Earnings 2002 $20,152 $ ,763 1, ,251 2, ,339 2, ,517 3, ,958 3, ,324 3, , ,588 2, ,138 4,928

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15 Wal Mart (In millions). Revenue Earnings 2002 $244,524 $ 8, ,329 8, ,222 10, ,427 11, ,650 12, ,799 12, ,607 13, ,214 14, ,849 15, ,950 15,766

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17 Sears Holding (In millions). Revenue Earnings 2003 $30,762 $ 3, , ,701 1, , ,012 1, , , , , ,567 3,113

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19 3. price/earnings ratio (P/E)

20 How the P/E works The price/earnings ratio (P/E) is a summary of the relationship between the current price per share, and latest reported earnings per share (EPS) To compute, divide price per share by earnings per share.

21 Problems with the P/E The P/E compares a current technical indicator (price) to an outdated fundamental indicator (earnings). The P/E multiplier is a reflection of how many years' earnings are in the current price. The higher the P/E, the more expensive the stock

22 Solutions to the P/E problem The P/E cannot be reliably used as a singular value at the moment. However, volatility of the stock can be judged by a review of the range of annual P/E and its trend. A consistent level of P/E in a narrow range is a positive indicator. For example, General Mills has reported a narrow P/E over many years.

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24 P/E rules of thumb Generally, a P/E between 10 and 25 is a positive signal. However, the trend is as important as where P/E is today. Irregular and volatile P/E is a sign of volatility in the stock and in the fundamentals. For example, Caterpillar has reported very erratic P/E range over recent years.

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26 4. dividend yield

27 Definition The meaning of dividend yield Dividend yield the percentage yield based on dividend declared and paid per share. To determine, divide dividend per share, by the current price per share. Example: a company currently pays $0.44 (fortyfour cents) per share. The price per share is $ Dividend yield is: = 2.2% Price is changing constantly, but the dividend declared per share does not change. As a result, dividend yield changes every day. The lower the price, the higher the yield. Examples: = 2.2% = 2.4% = 2.8%

28 The meaning of dividend yield To evaluate dividend yield, remember: Your dividend yield is always based on the price you paid per share. To judge a company s value, review dividend yield over many years, and not just what is paid today.

29 The meaning of dividend yield Compare two companies to see how dividend yield works. Both yielded 3.43% as of December 11, 2012: dividend per share Johnson Year Pfizer & Johnson

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31 The meaning of dividend yield In this comparison, Pfizer s dividend over 10 years was lower than Johnson & Johnson s. More significantly, Pfizer reduced its dividend per share over several year, while JNJ increased its payment every year.

32 5. dividend growth

33 Definition The meaning of dividend growth Dividend growth the percentage of increase each year in dividends per share, over payments in the previous year. Dividend growth may be more revealing than dividend yield. The rate of growth is a significant factor as a long term trend. The change from year to year in the dividend per share is a significant factor. Although a company may increase its annual dividend per share, if growth is declining, that has to be taken into account as well. Evaluating dividends should be a combination of dividend yield and dividend growth.

34 The meaning of dividend growth Compare two companies to see how dividend yield works. Both yielded 3.43% as of December 11, 2012: dividend per share dividend growth Johnson Johnson Year Pfizer & Johnson Pfizer & Johnson % 16%

35 The meaning of dividend growth These results tell the story of dividend growth. Although Pfizer s yield was erratic, the growth during positive years was impressive In comparison, Johnson & Johnson increased its dividend yield each year, but growth diminished.

36 6. debt ratio

37 Debt Ratio The debt ratio is a test of how well management plans and controls its cash flow. The debt ratio is the percentage of total capitalization represented by long term debt. Total capitalization is the combination of longterm debt and stockholders equity.

38 The meaning of debt ratio Definition Debt ratio the percentage of total capitalization represented by longterm debt. Total Capitalization the combination of long term debt and stockholders equity. Example: long term debt = $62.7 billion stockholders equity = 82.1 billion total capitalization = $ $82.1 = $144.8 billion debt ratio = $62.7 $144.8 = 43.3 Debt ratio is the percentage of total capitalization represented by long term debt. It is always expressed as a number without percentage signs. A debt ratio of 43.3 means that long term debt is 43.3% of total capitalization. When debt ratio is steady or falling, it is positive. When debt ratio is rising, it is negative.

39 The meaning of debt ratio For example, Eastman Kodak was for many years considered one of the strongest and best capitalized blue chip companies in the market. However, EK did not keep up with changing markets and when the digital camera boom arrived, they lost market share. In 2007, EK s debt ratio was about 30 but by the end of 2010, it was above 160. When debt ratio is over 100, it means debt has entirely absorbed equity. The company s stock is worthless.

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41 Conclusion Fundamental analysis is nothing more than the study of financial conditions and trends. It is imperative to analyze trend direction and strength over time. The fundamentals identify the value of companies and levels of competitive strength.