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This article appeared in the January 2013 ASX Investor Update email newsletter. To subscribe to this newsletter please register with the MyASX section or visit the About MyASX page for past editions and more details.

The first four things you should look at when using fundamental analysis.

Photo of Michael Kemp By Michael Kemp, Barefoot Blueprint

The sharemarket can be a daunting place for the first-time investor. What to buy and why? With conflicting advice coming from all directions, it can become rather confusing, and the best way to sift through all this noise is to develop some sound investment principles of your own. This article explores four things to look for.

1. Financial health

Investing is not just about chasing good returns, but also about not losing money and the chance of losing money is magnified when you invest in companies that are in poor financial shape. There are a number of tools you can use to evaluate a company's financial health, and the two below come close to the top of the list.

Debt-to-equity ratio

Companies fund their operations in two main ways. The first is through equity. That is, by issuing shares, which in effect is just selling off part of the business. The second is through debt, which is fine when economic times are good. But excessive levels of debt can cause problems when business conditions turn sour.

Lenders, unlike shareholders, demand payment whatever economic winds are blowing. They usually have the power to wind up a company unable to meet its debt obligations, and when this happens lenders usually get their money and there is little to nothing left over for shareholders.

As a potential shareholder you should look for companies that can comfortably service their debt. A useful measure for assessing this is the debt/equity ratio, which is easily calculated. Look at the company's most recent financial report and you will find the information you need in the Statement of Financial Position. The total debt figure is calculated by adding short-term debt (listed under current liabilities) to the long-term debt (listed under non-current liabilities). Debt is likely to be given a fancy name such as "interest-bearing liabilities". The figure for equity can be found at the bottom of the same statement. It will be listed as "total equity". The debt/equity ratio is calculated by dividing total debt by total equity.

It is best to invest in companies that own more than they owe. That is, they have a ratio of less than one. Although this is a useful rule of thumb, there is another important consideration: companies with reliable revenue streams are better placed to service debt in poor economic times; for example, a Coca-Cola Amatil or a Woolworths.

Worst placed are companies operating in cyclical business sectors, such as mining or discretionary retail. Their revenue streams are more variable, so if the company you are evaluating is exposed to the vagaries of the economic cycle, demand more conservative debt levels - a lower ratio.

Cash flow

To determine the profitability of a company, most investors turn to the Income Statement. But it is important to realise that these are the product of accounting concepts and the figures are based on accounting assumptions, judgments and interpretations. They are not always a true reflection of the cash flowing into or out of a business during the year.

The corporate graveyard is full of companies that reported a profit in their Income Statement just before they were put in the hands of the receivers.

Cash is king, and there is a way of checking how much cash the business generated during the year. Annual reports contain a Cash Flow Statement, which is split into three sections: the cash relating to operating, investing and financing activities. The section headed "net cash from operating activities" can be used to check the relevance of the Income Statement.

It is comforting to see reported net profit after tax (from the Income Statement) roughly agree with net cash from operating activities (from the Cash Flow Statement). They will not be exactly the same, but start asking questions if the reported net profit figure is significantly higher.

2. Enduring competitive advantage

Companies that have an advantage over their competitors often make great investments. For example, Coca-Cola has a highly recognised brand name; BHP Billiton owns world-class ore deposits. Companies that do not have a business advantage are more vulnerable to competition, leaving the playing field wide open to new entrants. As an increasing number of competitors vie for a fixed revenue pie, price wars break out and profitability for everyone suffers. Think airlines.

Developing an understanding of the company's business helps make this judgment; the dynamics of the sector, its future, consumer preferences, the threat of new technology. There's no simple way to determine this. It requires homework.

3. Company performance

Earnings growth

Now you are starting to gain some confidence your investment dollar will be safe, it is time to go to the next step in the analysis. You also want to achieve a good return on the investment, so start by looking for companies with a record of delivering growth in earnings per share. There are three important considerations:

  1. Look for a pattern of consistent growth.
  2. The growth needs to be sustainable and this is difficult if the company faces increasing competition. Under these circumstances, high growth levels (more than 10 per cent a year are unlikely to persist.
  3. Other investors are seeking earnings growth as well. This can inflate the share price, so don't pay too much when you find it.

Return on equity

Shareholders expect management to deliver a good return on the funds tied up in the business. The measure is return on equity (ROE), which, along with other metrics mentioned in this article, is readily obtainable from brokers' reports or websites. ROE is calculated by dividing earnings per share (EPS) by the book value per share for the same period. As a guide, it is nice to see ROE consistently higher than 15 per cent.

Many investors new to the sharemarket get confused. Return on equity does not measure the return on your share purchase. It refers to the return on shareholders' equity, which represents the value buried in the company net of any debt. Another common term for this is book value. Return on equity measures the return management is achieving on the shareholders' funds it has at its disposal. In a sense it is both a measure of management effectiveness and the profitability of the business sector in which the company is operating.

4. Valuation

You have now found a financially solid company with good prospects, being run by a management skilled at allocating capital. That's still not enough to declare it a buy. A great company can still be a lousy investment if the market is asking too high a price. Before you reach for your broker's phone number it is important to get a handle on what the shares you hope to buy are actually worth.

The biggest trap for unwary investors is to place too much faith in a metric called the price-earnings (PE) multiple. It is calculated by dividing the current share price by the most recently reported earnings per share. You will commonly hear it stated that a low PE indicates value. But, for all the reasons I indicated in the October 2012 ASX Update newsletter, this advice is ill-founded.

There is really only one way around this whole valuation issue, and that's by learning how to put your own price on the shares you are looking to buy. That is too big a topic for this article. But in the absence of further explanation, here is a small tip that might help.

Add the dividend yield (annual dividend divided by the current share price) to the annual rate of earnings growth (over the past several years). If the sum is close to 10 then you are looking at about fair price. But this is only a rule of thumb. To become a fully fledged investor you need to develop your own sense of value.

About the author

Michael Kemp is chief analyst at The Barefoot Blueprint.

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