Fundamental Analysis Tips
Practical tips for reading statements, using ratios, valuation, screening, avoiding red flags, and using resources. Use with the Fundamental Analysis and Book Notes content.
1. Reading Financial Statements
Start with the 10-K/10-Q: Read Management Discussion & Analysis (MD&A) and Risk Factors first. They explain what management sees as drivers and risksâcompare with your own view.
Three statements together: Never look at income statement alone. Check cash flow (operating CF vs net income) and balance sheet (debt, liquidity). Earnings can be boosted while cash flow lagsâa red flag.
Quality of earnings: Prefer recurring revenue and earnings. One-time gains, asset sales, or accounting changes that flatter earnings should be stripped out for a ânormalizedâ view.
Sequential and YoY: Look at quarter-over-quarter and year-over-year trends. Single snapshot (one quarter) can be misleading; trends show direction.
Footnotes: Donât skip footnotes. They explain accounting policies, one-time items, debt terms, and contingent liabilities that can materially affect value.
2. Ratio Tips
Compare to peers and history: A P/E of 20 means little in isolation. Compare to sector average and to the companyâs own history (e.g. 5-year average P/E). Same for margins, ROE, debt ratios.
ROE decomposition: ROE = Net margin Ă Asset turnover Ă Leverage. High ROE from leverage alone is riskier than from margin or turnover. DuPont analysis helps.
Liquidity: Current ratio > 1 is basic; quick ratio (excluding inventory) is stricter. For cyclical or inventory-heavy firms, watch working capital trend.
Debt: Debt/Equity and interest coverage (EBIT/Interest) matter. Low coverage in a downturn can force distress. Prefer companies that can pay down debt from operating cash flow.
Valuation multiples: P/E is distorted by one-time items and different accounting. EV/EBITDA is better for capital-intensive or different tax situations. P/FCF (price to free cash flow) aligns with DCF thinking.
3. Valuation Tips
DCF sensitivity: Run DCF with bull, base, bear assumptions (growth rate, discount rate). If fair value is only above price in the bull case, margin of safety is thin.
Margin of safety: Graham/Buffett style: buy only when price is meaningfully below your estimate of value (e.g. 20â30%+). Protects against estimation error and bad luck.
Donât anchor to market price: Value the company from scratch (cash flows, multiples) before looking at current price. Then compare. Anchoring to âitâs down 50% so itâs cheapâ leads to value traps.
Check assumptions: If your DCF implies perpetual growth above GDP for a long time, question it. Terminal growth should be modest (e.g. 2â3%) unless thereâs a clear reason.
Relative valuation: When using multiples, adjust for growth and risk. A high-growth, low-risk company can justify a higher P/E than a no-growth, high-risk peer.
4. Screening and Idea Generation
Screen by multiple factors: Combine quality (ROE, margins, low debt) with value (low P/E or P/B, high FCF yield) or growth (revenue growth, earnings growth). Avoid screens that only use one metric.
Sector and cycle: Understand where the sector is in its cycle (e.g. commodities, housing). A âcheapâ stock in a sector thatâs peaking can stay cheap or get cheaper.
Catalyst: Ask âwhat will make this reprice?â (e.g. earnings beat, new product, margin improvement, activist). Without a catalyst, undervaluation can persist for years.
Circle of competence: Focus on industries you understand. Avoid complex financials or biotech unless youâre willing to do deep work. Sticking to your circle improves accuracy of valuation.
5. Red Flags
Earnings up, cash flow flat or down: Possible aggressive accounting or one-time gains. Prefer companies where operating cash flow tracks or exceeds net income over time.
Rising receivables vs revenue: If receivables grow faster than revenue, revenue recognition may be aggressive or collections are slowing.
Frequent âone-timeâ charges: Recurring âone-timeâ items suggest theyâre not one-time. Normalize earnings by excluding or averaging them.
Off-balance-sheet and contingent liabilities: Check footnotes for leases (pre-IFRS 16), guarantees, litigation. They can become real liabilities.
Management compensation vs performance: If pay is high while returns are poor or capital allocation is bad, governance may be weak.
Auditor or CFO changes: Can signal accounting or internal disagreement. Not always bad, but worth a closer look.
6. Qualitative and Management
Moat: Identify one or more sources of advantage (brand, scale, network, switching costs). Ask: âCan a competitor take this business in 5â10 years?â
Capital allocation: Track how management uses cash (reinvest, dividends, buybacks, M&A). Consistent value-destructive M&A or buybacks at high prices are red flags.
Transparency: Prefer management that explains clearly (letter to shareholders, calls). Vague or evasive answers on tough questions are a concern.
Insider ownership and trading: Meaningful insider ownership aligns interests. Selling by insiders can be routine (diversification) or a signalâcheck context and size.
7. Resources and Workflow
Free data: Yahoo Finance, company IR, SEC EDGAR (10-K, 10-Q, 8-K). Morningstar for ratios and history. Good enough for a first pass.
Consistency: Use the same source for ratios across companies (e.g. same definition of âearnings,â same period). Mixing sources can give inconsistent comparisons.
Checklist: Keep a written checklist (statements read, ratios computed, DCF assumptions, red flags, moat) so you donât skip steps when you like a story.
Invert: Ask âwhy would this not work?â and âwhat would make me sell?â If you canât answer, youâre not ready to buy.
8. Combining With Technicals and Options
FA for selection, TA for timing: Use FA to build a watchlist of quality and value; use TA to time entry (e.g. pullback to support, breakout) and set stops/targets.
Options: Use options to express a fundamental view (e.g. long-dated call on undervalued stock) or hedge (protective put). Donât use options to override a weak fundamental thesisâsize and expiration should reflect conviction.
See also: Fundamental Analysis Summary | Book Notes.
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