Qualitative and Quantitative Fundamentals
Qualitative Fundamentals
There are four key fundamentals that analysts always consider when regarding a company. All are qualitative rather than quantitative. They include:
- The Business Model
What exactly does the company do? This isn’t as straightforward as it seems. If a company’s business model is based on selling fast-food chicken, is it making its money that way? Or is it just coasting on royalty and franchise fees?
- Competitive Advantage
A company’s long-term success is primarily driven by its ability to maintain a competitive advantage—and keep it. Powerful competitive advantages, such as Coca-Cola’s brand name and Microsoft’s domination of the personal computer operating system, create a moat around a business allowing it to keep competitors at bay and enjoy growth and profits. When a company can achieve a competitive advantage, its shareholders can be well rewarded for decades.
- Management
Some believe management is the most important criterion for investing in a company. It makes sense: Even the best business model is doomed if the company’s leaders fail to execute the plan properly. While it’s hard for retail investors to meet and truly evaluate managers, you can look at the corporate website and check the resumes of the top brass and the board members. How well did they perform in previous jobs? Have they been unloading a lot of their stock shares lately?
- Corporate Governance
Corporate governance describes the policies in place within an organization denoting the relationships and responsibilities between management, directors, and stakeholders. These policies are defined and determined in the company charter, its bylaws, and corporate laws and regulations. You want to do business with a company that is run ethically, fairly, transparently, and efficiently. Particularly note whether management respects shareholder rights and shareholder interests. Make sure their communications to shareholders are transparent, clear, and understandable. If you don’t get it, it’s probably because they don’t want you to.
- Industry
It’s also important to consider a company’s industry: its customer base, market share among firms, industry-wide growth, competition, regulation, and business cycles. Learning how the industry works will give an investor a deeper understanding of a company’s financial health.
Quantitative Fundamentals: 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.
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):
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. 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.
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.