Fundamental analysis (FA) refers to the process of examining a company to assess its suitability for investment. According to The Bedokian Portfolio eBook, there are three tiers in FA: financial statements, environmental factors, and economic conditions. The analysis can be conducted using either a top-down or bottom-up approach.
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At the financial statement level, the company's income statements, balance sheets, and cash flow statements are looked at. Environmental factors are considered the "playing field”, encompassing elements such as competitors and governing regulations; the so-called "rules of the game”. Economic conditions refer to broader influences, including inflation rates, geopolitical developments, and other macroeconomic variables.
To detail the entire FA warrants writing a separate book, to which there are already a lot out there, and FA is not a one-size-fits-all kind of thing, hence I only scoped it to ratio analysis according to my selection guidelines. I had quoted this in my eBook: “…a full FA is to be carried out in conjunction with the selection guidelines” (it is at page 102 by the way), so it needs to work together with whatever FA being employed. However, some readers might find it incomplete since I left out much material.
In this post, I will outline my selected methods in conducting financial analysis, along with further perspectives on qualitative elements, particularly those extending beyond financial statements.
Valuation Methods
The eBook introduces several financial ratios, including the price-to-book (P/B), price-to-earnings (P/E), and P/E-to-growth (PEG) ratios.
The P/B ratio is often applied to most Singapore Exchange (SGX) listed equities, as some blue chip stocks are described as being traded "within the P/B band”, which is calculated based on standard deviations.
For equities in other regions, particularly growth-oriented stocks or those listed in United States (U.S.) markets that are seldom near their P/B, the PEG ratio is employed instead.
The P/E ratio serves as a comparative tool for ranking companies within the same sector or industry. Dividend yield is also considered, especially for dividend-focused investors like us, with a preference for yields that exceed the 10-year average inflation rate, though exceptions may be made for U.S. stocks, which typically have lower yields than local ones.
It is important to note that these ratios provide only a partial perspective, reflecting just a snapshot based on current or historical data. Further analysis of the numbers behind these ratios is essential, which involves reviewing financial statements such as revenues, net profits, and free cash flows. While valuation techniques like discounted cash flow (DCF) and dividend discount models (DDM) are recognised, I do not apply them often due to the numerous assumptions required.
Environmental Factors
Often referred to as the playing field, assessing a company's position within its sector or industry typically involves comparison with peers. This process can be complex due to overlapping business activities; for instance, while Coca Cola and PepsiCo are leading companies in the cola beverage sector, PepsiCo also operates in snacks and potato chips, whereas Coca Cola primarily focuses on beverages. Similarly, Apple and Samsung, prominent smartphone manufacturers, offer additional products not always in direct competition, such as televisions.
To enhance these comparisons, alternative data sources can be useful. Market share reports from research firms provide relevant statistics, though recent or detailed information may require paid subscriptions; however, some figures are available through financial news outlets. Company projections shared in quarterly and annual reports offer insights into expected developments from the management's perspective. In addition, primary data collection, sometimes called ‘scuttlebutting’, can provide personal observations that supplement formal research, such as noting the prevalence of certain products in specific regions (e.g., my observation of a lot of iPhone users in Japan).
Environmental factors also play a role in evaluating companies, including the concept of an economic moat described by Warren Buffett. While monopolies typically have significant moats, there is the risk of antitrust actions by regulators; thus, attention is often given to near-monopolies, market leaders, or brand leaders within a given industry.
Economic Conditions
At this level, outcomes are often unpredictable due to factors that are outside of our direct understanding or control. Here, analysts, economists, and fund managers frequently provide predictions (read: guesswork) based on available information, which may influence the analysis of the underlying tiers, i.e., environmental factors and financial statements.
Given the uncertainty, “guesstimates” (guessing + estimates) are generally made by referencing historical precedents and current data, though these assessments may not always be accurate. Some developments can be anticipated using macroeconomic knowledge—such as expecting interest rates to increase during periods of high inflation—while others, such as unexpected global events (e.g. COVID-19) or shifts in trade policies (e.g., tariffs), are more difficult to foresee.
Being adaptable in response to likely future changes allows for strategic decisions, such as applying associative investing methods (page 137-138 of the eBook), to potentially benefit from emerging opportunities.
Wrapping Up
The points above outline my general approach to FA, though my methods may vary based on the company, sector, region, or country being researched. While some FA tools and figures are standard, it is often tailored to each situation since perspectives and interpretations differ among investors.
Disclosure
The Bedokian is directly vested in Apple.
Disclaimer
