How To: Company Fundamentals
The fundamentals of a stock – why are they so important?
During times when the stock market is on the up and all is well with the economy, it is easy to think that making money on the markets is a simple matter. Just pick the most-profitable companies and the successful sectors, bank the generous dividends, sit back, and watch the value of your holdings rise. You can’t go wrong, can you? Oh, yes, you can! To win in the investment game, you have to know what you are doing. That is why, even in the good times, researching the ‘fundamentals’ (the health) of a company before committing your money is vital.
Why this is so important
If for, some unanticipated reason, the market falls dramatically – perhaps due to a significant financial crisis, a geopolitical problem, or something similar to the disastrous COVID-19 pandemic, everyone will take a hit. But if you have unwisely chosen to invest in a company that is poorly managed, proves to be financially unstable, or has debt that is getting out of control, you will see the value of your shareholding decrease, perhaps very quickly and often dramatically. If you had researched the fundamentals, such a poor investment decision would have been avoided. Investors that conduct comprehensive research into companies have a far better chance of making wise investments based on hard facts. That is why I cannot stress strongly enough how important it is to research a stock properly before clicking on that ‘buy’ button.
Follow their example
What do the professional fund managers do when deliberating whether or not to put money into a particular stock? Answer: they study the fundamentals, the basics, the detail, the nitty-gritty of the company under consideration; they assess the intrinsic value. That involves an in-depth analysis of how a company has performed in the past, its current performance and its prospects for growth. A thorough review of this kind is not to be confused with technical analysis, which looks at the trading and price history of a stock.
So, what are the fundamentals (the basics), and how do we go about researching them?
- Return on assets
- Profit retention to fund future growth
- Cash flow
- Sensible gearing
- Quality of management
- Shareholder earnings
- Underlying value
- Financial stability
The aim is to build up a comprehensive picture of a company. Start by studying the financial information reported in annual and quarterly statements; press releases that are issued and look for anecdotal reports from suppliers and customers. Also, research how high a demand there is for the company’s products. Does it have an enthusiastic, ambitious management team? Access to that kind of information is so much easier now that we have the Internet.
The following information about a company can be obtained from the government website at https://www.gov.uk/get-information-about-a-company.
- The registered address and date of incorporation
- The current and resigned officers
- Document images
- Mortgage charge data
- Any previous company names
- Any insolvency information
If the shares of a company are trading on the London Stock Exchange, that company must publish an annual report. If you are a shareholder in the company, you will receive the report through the post. The company’s and the stock exchange’s website also have a facility for downloading annual reports.
The annual reports include statements from the chief executive and chairman of a company detailing how the business has performed over the year. It will also set out the management’s objectives for the next year and reveal the most significant achievements of the company over the preceding twelve months. Also included are details about what the company does, where it operates and how it interacts with its stakeholders.
Also included in annual reports are the company’s financial results plus any share options or incentive plans proposed. Furthermore, also stated will be the details of the directors’ remuneration, something that is often of interest to shareholders.
It seems appropriate at this point to include a quote from Warren Buffett: “Do not take yearly results too seriously. Instead, focus on four or five-year averages.”
Useful information about company fundamentals is available in various financial publications. For news about the UK’s business and economy, the Financial Times is the go-to source, while the Wall Street Journal provides US financial news. Many investors also refer to Barron’s; its original reporting is particularly appreciated. All the traditional news sources about commerce now have excellent websites that are continually updated.
It cannot be stressed enough how vital it is to conduct thorough research into a business before you commit your money. If some investors spent as much time researching a potential investment as they do when selecting a new smartphone, fewer bad investment decisions would be made.