The six fundamental indicators every investor must use

The six fundamental indicators every investor

must use

Definition

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.

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.

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

1. growth in revenues

The nature of revenue growth

What should you expect to see?The trend and how it changesThe tendency for trends to level outRevenues are tied to earningsRevenue dollar values should growEarnings percentage should be consistent

Problems with revenue

Revenues trend erratically

Revenues grow while earnings do not

Revenues remain level or begin to slide

2. growth in earnings

How earnings grow

Net return should remain consistent or rise

The net dollar value should grow as well

Seek consistent earnings trends

Problems with earnings

The net return declines even if dollar amount grows

Revenues outpace the net return

Revenues grow while earnings move to negative

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

General Mills (In millions) . Revenue Earnings2003 $10,506 $ 9172004 11,070 1,0552005 11,244 1,2402006 11,640 1,0902007 12,442 1,1442008 13,652 1,2952009 14,691 1,3042010 14,797 1,5312011 14,880 1,8042012 16,658 1,567

Caterpillar (In millions) . Revenue Earnings2002 $20,152 $ 7982003 22,763 1,0992004 30,251 2,0352005 36,339 2,8542006 41,517 3,5372007 44,958 3,5412008 51,324 3,5572009 32,396 8952010 42,588 2,7002011 60,138 4,928

Wal-Mart (In millions) . Revenue Earnings2002 $244,524 $ 8,0392003 256,329 8,8612004 285,222 10,2672005 312,427 11,2312006 348,650 12,1782007 378,799 12,8842008 405,607 13,2542009 408,214 14,4142010 421,849 15,3552011 446,950 15,766

Sears Holding (In millions) . Revenue Earnings2003 $30,762 $-3,2622004 17,072 2482005 19,701 1,1062006 49,124 9482007 53,012 1,4902008 50,703 8262009 46,770 532010 44,043 2352011 43,326 1502012 41,567 -3,113

3. price/earnings ratio (P/E)

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.

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

Solutions to the P/E problemThe 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.

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.

4. dividend yield

Definition

The meaning of dividend yield

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:

0.44 ÷ 20.00 = 2.2% 0.44 ÷ 18.00 = 2.4% 0.44 ÷ 16.00 = 2.8%

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 (forty-four cents) per share. The price per share is $20.00. Dividend yield is:

0.44 ÷ 20.00 = 2.2%

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.

The meaning of dividend yieldCompare two companies to see how dividend yield works. Both yielded

3.43% as of December 11, 2012: dividend per share

JohnsonYear Pfizer & Johnson2002 0.52 0.802003 0.60 0.932004 0.68 1.102005 0.76 1.282006 0.96 1.462007 1.16 1.622008 1.28 1.802009 0.80 1.932010 0.54 2.112011 0.80 2.25

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.

5. dividend growth

Definition

The meaning of dividend growth

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.

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 meaning of dividend growthCompare 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 & Johnson2002 0.52 0.802003 0.60 0.93 15% 16%2004 0.68 1.10 13 182005 0.76 1.28 12 162006 0.96 1.46 26 142007 1.16 1.62 21 112008 1.28 1.80 10 112009 0.80 1.93 -38 72010 0.54 2.11 -68 92011 0.80 2.25 48 7

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.

6. debt ratio

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 long-term debt and stockholders’ equity.

Definition

The meaning of debt ratio

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.

Debt ratio– the percentage of total capitalization represented by long-term 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 = $62.7 + $82.1 = $144.8 billion debt ratio = $62.7 ÷ $144.8 = 43.3

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.

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.