Fundamental Analysis

Common sense and logic prevail over market hype
Fundamental investing involves the analysis of a company's financial data to determine whether a company is of sound 'fundamental' value. Many so-called professional investors (be they brokers or fund managers) are regularly confused or caught out by not appreciating the true fundamental health of a particular company.

Many tools are used to assess a company's health with some being better than others. Earnings per share (EPS), PE ratios, multiple compression (the latest buzz words), gearing, enterprise value, EBITDA, EPS growth rates, return on capital, and cost of capital are many such items which can be confusing. However, understanding a couple of these measures can be extremely useful for all types of investors.

Cash Flow is King
The first investment equation worth remembering is:

Revenue less Costs = Cash Flow

This equation works for all businesses from a local lawn-mowing operator, up to a company the size of BHP Billiton. Understanding the broad dynamics of revenue and costs ultimately assists in determining how much revenue ends up in the Company's bank account, and therefore (potentially) what shareholders can expect at the end of the year.

Everyday you will hear or see something that may affect revenue or costs of various businesses. Investors need to consider what these impacts will be and how to profit from them. For instance:

• If it doesn't rain, crops (and lawns) don't grow. Therefore the revenue of farmers and companies that supply rural industries will shrink, so to will the revenue of our local lawn-mowing operator.
• At the bottle shop when you notice your favourite bottle of red is consistently on special. This means the wine companies must be discounting and thus their revenue must be shrinking.
• The oil price is in the news at the moment as it is at record highs. Of course airlines use tonnes (and tonnes) of fuel so their costs must have risen reducing their revenue.

Obviously unless the company does something to offset these changes then it will generate less cash. Thus, there is no surprise in seeing Qantas pass on fuel costs via a ticket surcharge, and wine companies attempting to pay lower prices for grapes.

So a critical aspect of fundamental investing is a broad understanding of what impacts a particular company's revenue and cost base. Usually both items are discussed in the company's Annual Report (these days readily available from the company's website) as well as broader industry updates that can be read in newspapers and magazines, or from television reports and documentaries.

Annual Report
Among other things the Annual Report contains the company's balance sheet, profit and loss statement, and cash flow statement. These are the key sources of information for fundamental analysis. In particular a cash flow statement will greatly assist in making assumptions about a company's current and future financial health.

Understanding the King!
If cash flow is King then you should understand the King. There are at least three cash flow levels we need to know - Cash Flow from Operations, Operating Cash Flow and Free Cash Flow. The former two are usually provided by the company, the later which is the most important, in many instances is not.

• Cash flow from operations is exactly that, cash provided by the company's various operations. It is before corporate overheads, interest costs, tax paid and, if appropriate, research and development and/or exploration expenses.
• Operating cash flow, or net cash inflow from operating activities, comes after these items (tax paid, interest, corporate costs, and usually R&D/exploration) are subtracted from the cash flow from operations.
• Free cash flow is our primary area of interest and should be viewed as the cash generated after all these items with one additional item, being the sustaining or stay in business capital spend, are then deducted from the cash flow from operations. The free cash flow can be regarded as what is left over after all funds required to keep the business running as it currently stands have been deducted.

Strong, robust companies usually separate capital spend into the two sub-categories of sustaining (or stay in business) and growth making it easier to get an idea of the level of free cash, whereas other companies sometimes present sustaining capital as growth capital. While the company's statements give one part of the free cash flow picture investors also need to pay careful attention to the management reviews, presentations, and other statements in the Annual Report to get an idea of what expenses the company currently has and what they are likely to have in the future.

Free cash flow is one of the most important figures to watch as it can be the difference between a company appearing to generate $100m in operating cash flow to a company that could actually be generating negative free cash flow.

Once this item is understood then investors can have some confidence that the company they are about to invest in does generate sufficient cash to meet dividends, growth, debt repayments and unforeseen commitments. Over time an experienced investor should then be able to determine if their estimate of free cash flow reconciles with a company's profit and loss and operating cash flow statements.

Once you understand this principle, you can apply some logic to the direction of a company's revenue and costs in the future, and these figures can then be cross checked against the estimated free cash being generated by the business. If in doubt ask your stockbroker for a brief breakdown on each of the components on a company before investing. Or join ASX's free online class "Analysing & Selecting Shares" to learn more about fundamental analysis.

For more information on Shaw Stockbroking's services please visit the Egoli website www.egoli.com.au.

© Shaw Stockbroking Ltd all rights reserved 2004. This article has been provided by SHAW Stockbroking Ltd. ASX does not represent or warrant that the information contained herein is complete or accurate. The views of the author are their own and not those of ASX. You should seek independent advice from a licensed professional before making any financial decisions. To the extent permitted by law, no responsibility for any loss arising in any way (including by way of negligence) from anyone acting or refraining from acting as a result of this information is accepted by ASX.

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