Quantitative Fundamentals to Consider: Financial Statements
Financial statements are the medium by which a company discloses information concerning its
financial performance. Followers of fundamental analysis use quantitative information from
financial statements to make investment decisions. The three most important financial statements
are income statements, balance sheets, and cash flow statements.
The Balance Sheet
The balance sheet represents a record of a company's assets, liabilities, and equity at a particular
point in time. It is called a balance sheet because the three sections—assets, liabilities, and
shareholders' equity—must balance using the formula:
Assets = Liabilities + Shareholders' Equity
Assets represent the resources the business owns or controls at a given time. This includes items
such as cash, inventory, machinery, and buildings. The other side of the equation represents the
total financing value the company has used to acquire those assets.
Financing comes as a result of liabilities or equity. Liabilities represent debts or obligations that
must be paid. In contrast, equity represents the total value of money that the owners have
contributed to the business—including retained earnings, which is the profit left after paying all
current obligations, dividends, and taxes.
The Income Statement
While the balance sheet takes a snapshot approach in examining a business, the income
statement measures a company's performance over a specific time frame. Technically, you could
have a balance sheet for a month or even a day, but you'll only see public companies report
quarterly and annually.
The income statement presents revenues, expenses, and profit generated from the business'
operations for that period.
Statement of Cash Flows
The statement of cash flows represents a record of a business' cash inflows and outflows over a
period of time. Typically, a statement of cash flows focuses on the following cash-related
activities:
Cash from investing (CFI): Cash used for investing in assets, as well as the proceeds
from the sale of other businesses, equipment, or long-term assets
Cash from financing (CFF): Cash paid or received from the issuing and borrowing of
funds
Operating Cash Flow (OCF): Cash generated from day-to-day business operations
The cash flow statement is important because it's challenging for a business to manipulate its
cash situation. There is plenty that aggressive accountants can do to manipulate earnings, but it's
tough to fake cash in the bank. For this reason, some investors use the cash flow statement as a
more conservative measure of a company's performance.
Example of Fundamental Analysis
The Coca-Cola Company is a prime example that can be used in fundamental analysis. To begin,
an analyst would examine the economy using some published metrics:
Consumer price index (inflation measure)
Gross domestic product growth
Exports/imports
Purchasing manager's index
Interest rates
Then, the sector and industry would be examined using statistics and metrics from various
reports and competitor companies. Lastly, the analysts would gather the reports from Coca-Cola
or the Security and Exchange Commission's Edgar filings database.1
Analysts might also use data gathered by another firm, such as CSIMarket. CSIMarket provides
fundamental analysis data for investors, so you could begin by assessing the value of Coca-
Cola's assets, income streams, debts, and liabilities. You might find comparisons of objective
metrics such as revenue, profits, and growth, especially in the context of the broader beverage
industry.
Using CSIMarket's analysis, the analyst could compare growth rates to the industry and sector
Coca-Cola operates in, along with the other information provided, to see if the company is
valued correctly. For example, as of August 2022, for the trailing twelve months (TTM), Coca-
Cola had (using only a few of the possible ratios and metrics):2
One factor not shown in an analysis of ratios and numbers is how long a company has been
around and the conditions they have weathered. Coca-Cola was founded in 1892 in Atlanta,
Georgia.3 It has stayed in business through several wars, depressions, recessions, epidemics,
pandemics, stock market crashes, and a global financial crisis. Not many companies can claim a
history like that.
So, an analyst can combine brand, longevity, growth above that of the beverages manufacturing
industry, an above average price-to-earnings ratio, and good return on investment.
Coca-Cola has more debt than equity, but it also generates more returns using its assets than the
rest of the industry. The company doesn't have as much liquidity as other companies, but it
seems the industry hovers on pretty low quick ratios. More than 1.0 means a company can pay its
short-term obligations quickly—so in general, most of the industry is low, but Coca-Cola has
more than $1 billion in net cash flows, which gives it a lot of wriggle room.4
An interesting measurement is how much revenue one employee generates. Coca-Cola
employees generate about twice as much revenue as employees for comparative companies. This
might warrant a deeper investigation into what Coca-Cola is doing differently. They may have
invested in new technology or have much more efficient systems. Looking over press releases
and reading company reports can provide insights into what the company is doing. It might also
be that Coca-Cola simply sells more products than its competitors, so it's important to review any
reports and releases and conduct a fundamental analysis carefully.
Determining Stock Values
An investor should use fundamental analysis to determine if a stock is undervalued, overvalued,
or trading at fair market value.
If the investor examines all the available information about a corporation’s future anticipated
growth, sales figures, cost of operations and industry structure, that analysis will provide the
intrinsic value of the stock.
To a fundamental analyst, the market price of a stock tends to move towards its intrinsic value. If
the intrinsic value of a stock were above the current market price, the investor would purchase
the stock. However, if the investor found, through analysis, that the intrinsic value of a stock was
below the market price for the stock, the investor would sell the stock from their portfolio or take
a short position in the stock.
Investment analysts are the ones typically charged with trying to determine the “intrinsic value”
of a stock. They want to figure out what it is really worth to investors, because its historical cost
seldom reflects its actual value or its market valuation.
There are several steps associated with fundamental analysis. These analysts must first examine
the current and future overall health of the economy as a whole and then attempt to determine the
level of interest rates. This may be done through interest rate forecasting. An understanding of
the relevant industry sector, including the maturity of the industry and its cyclicality, as well as
how it is affected by the economic cycle will be required.
Once these steps have been undertaken, then the individual firm must be analyzed. This is the
major focus of the “bottom up” investment analysis. Rather than make investment decisions
based on “top down” macroeconomic, social and political changes, the analysis concentrates on
the company concerned. This analysis must include the factors that give the firm a competitive
advantage in its sector (low cost producer, technological superiority, distribution channels, etc.).
Additionally, factors such as management experience and competence, history of performance,
accuracy of forecasting revenues and costs and growth potential, among others, should also be
examined.
After doing the analysis above, the analyst develops her qualitative view of the firm’s position
within its sector and within the economy as a whole. This is necessary in order to understand
whether a quantitative analysis should be undertaken.
If the analyst is sufficiently impressed with the issuer in question, then he is ready to develop a
financial model of this firm. The analyst will usually use a spreadsheet to analyze and model the
financial statements.
Once the quantitative description of the company is complete, there are two relatively simple
models that can be helpful for the investor willing to better understand the firm under scrutiny.
The two most commonly used methods for determining the intrinsic value of a firm are the
“Dividend Discount Model”, often called the Gordon Growth Model after the Canadian
professor who developed it, and the Price/Earnings or PE model. If employed properly, both
methods should produce similar intrinsic values.
Dividend Discount Model
When using the dividend discount model, the type of industry involved and the dividend policy
of the industry is important in choosing which of the dividend discount models to employ. As
mentioned earlier, the intrinsic value of a share is the future value of all dividend cash flows
discounted at the appropriate discount factor. For those familiar with the calculation of yield in
fixed income analysis, the concepts are similar.
For Constant Dividends:
P=Dt/ke where:
P = intrinsic value
Dt= expected dividend
ke= appropriate discount factor for the investment
This method is useful for analyzing preferred shares where the dividend is fixed. However, the
constant dividend model is limited in that it does not allow for future growth in the dividend
payments for growth industries. As a result, the constant growth dividend model may be more
useful.
For Constant Dividend Growth:
P=Dt/(ke-g) where:
P = intrinsic value
Dt = expected dividend
ke = appropriate discount factor for the investment
g = constant dividend growth rate
The constant dividend growth model is useful for mature industries where the dividend growth is
likely to be steady. Most mature blue chip stocks may be analyzed quickly and easily with the
constant dividend growth model. This model has its limitations when considering a firm that is in
its growth phase and will move into a mature phase at some time in the future. A two-stage
growth dividend model may be utilized in such situations. This model allows for adjustment to
the assumptions of timing and magnitude of the growth of the firm.
For the Two Stage Growth Model:
If a company is growing quickly and looks like its growth will slow, the dividend growth model
can be adapted to provide for two stages of different dividend growth. The formula is given
below:
P=Σnt=1[D0(1+g1)t/(1+ke)t]+Σ∞t=n+1[Dn(1+g2)t-n/(1+ke)t]
where:
P = intrinsic value
D0= expected initial period dividend
Dn= expected dividend during mature period
ke = appropriate discount factor for the investment
g1 = expected dividend growth rate for initial growth period
g2 = expected dividend growth rate for mature period
The two-stage model allows for greater flexibility in the testing of scenarios for the investor
looking at a firm in its infancy or in a new industry.
Price Earning Model
The Price Earnings model takes the earnings per share of a company and multiplies it by the
Price Earnings Ratio. This model has the benefit of simplicity, in that it can be calculated quickly
if one has the Earnings Per Share (EPS) and share price by simply dividing the share price by the
EPS.
Companies can then be easily compared and estimates made for the target company on this basis.
For example, if the best company in the industry had a PE multiple of 20 times and the worst a
PE multiple of 10 times, then an average company in the industry might have a 15 times PE
multiple. Taking the average company’s EPS, say $1.00 per share, and multiplying it by 15
would give an intrinsic value of $15.
Judging companies based on their intrinsic value is a useful way to get around a lot of the noise
associated with macroeconomic or political factors and get to the core of a company’s real value,
which provides an investor with clear information to make decisions about what any stock is
worth.
