My Fundamental Analysis Review, How to Review Financial Statements

If the layman would call technical analysis a democrat, then fundamental analysis is absolutely a hard-core republican by nature. Fundamental analysis lacks the creativity and arbitrary element that technical analysis can sometimes have, and prefers to go by the book, in a brass tacks manner, more so than leaving things open to interpretation (I use this analogy in that liberals tend to be lenient on black letter law while republicans are more “if it’s in the law it must be right” in their thinking…case you didn’t get the analogy.) Fundamental analysis takes the no bs route to picking stocks, in that it goes straight to what a lot of traders and investors out there, including yours truly, Warren Buffet and Benjamin Graham, feel is the only thing that really matters, which is the fundamentals, or the financial statements and financial ratios, of the company. This chapter will look into why fundamental analysis should be an extremely well thought out and important part of your investment strategy, and of why, even with the power of this financial tactic in your tool belt, that holding a well-diversified passively managed index fund commensurate with your risk tolerance, over the long term, is still the way to go. Be sure to subscribe to our blog for more details and information, and to comment down below with your thoughts and opinions, and we’ll get back to you within one business day with a response. And so, without further ado, here is my fundamental analysis review, and my thoughts on how to accurately read financial statements.

How to Read Financial Statements In a Nutshell, A Fundamental Analysis Review In Its Fullest

The gist of fundamental analysis, while still very much leaps and bounds ahead of that of technical analysis, lies in a few fundamental assumptions that aren’t necessarily 100% accurate. For one, a large part of fundamental analysis uses mathematical calculations and formulas, such as projecting and discounting future cash flows, in order to make assumptions about a particular stock or company. In doing this we find that a few things are lacking in this approach, even though reading the financial statements of a company and going off of this is a much better tool than reading technicals. These flawed assumptions, can be summed up as follows:

  1. Randomness plays a major part in how stocks move, both in the short term and in the long-Even through reading the financial statements of a company and looking at its overall fundamentals can be an overall fantastic tool for picking stocks in comparison to the rest of the strategies out there, it doesn’t consider randomness of events. When taking into account things like black swan events such as 9/11, the dot com bubble, the 2007 and 2008 mortgage crisis, and the like, you can see how reading the financial statements of a company as a way to pick individual stocks has its downsides and isn’t always 100% accurate. Technical analysis and momentum can and may at certain time periods get involved with the movements of stocks, especially in the short term.
  2. Earnings reports aren’t necessarily always 100% accurate-A lot of the earnings reports will use accounting tricks in order to overstate or understate their net income, some of which are completely legal to use, like you get nowadays, and some of which were completely fraudulent, such as in the Madoff scandal of the late 20th century, or in the case of the collapse of Enron and the accounting fraud encased therein. While once again, reading the earnings report of a company that you are going to be investing in is absolutely imperative to you being a sound investor, the chances of you deciphering the information incorrectly or making a bad stock buy due to all of the available information that you’re reading already being incorporated into the overall market is actually rather high, so even with the benefits of fundamental analysis, holding an index fund is still your best bet. As for those accountingFundamental Analysis Review tricks that are legal that deceive the earnings report numbers, companies will occasionally have high levels of free cash flow (the real metric for how much cash flow a company has in any given period) and will distribute this free cash flow towards scaling up the business, thus avoiding taxes legally, and keeping more of their money to increase their free cash flow in future quarters, and so on, and so on. Free cash flow, abbreviated as FCF, will be discussed in more detail in a bit.
  3. Analysts are still human- A lot of the information that you’ll see on TV regarding earnings reports and news about a new distribution network that a company is including into its product line, etc. can be strongly considered as fundamental analysis, however in many cases, not all of the fundamental analysis will be correct, and even if all of it is correct, not all of it is new information that you can use to pick stocks that hasn’t already been incorporated into a stocks price. Unless you’re getting advanced copies of the Chipotle Mexican Grill earnings report before it comes out to the public, and are buying up shares due to hidden knowledge that is material and nonpublic (which the SEC typically frowns upon, see insider trading laws for more information), than the vast majority of the information contained in earnings reports has already been included in the stocks price, and will not aid you in seeking out alpha stock market returns.
  4. Projecting future cash flows, and for that matter discounting them, is not 100% accurate, A huge fundamental analysis review point-If you go the way of the academic, projecting future cash flows is done by using a combination of the short and long run growth rate of free cash flow. Now, why free cash flow and not net income, as isn’t net income another word for “earnings” which is one of the hugest fundamental analysis metrics that you are likely to see day after day on the news? The reason that we use free cash flow rather than net income is that the number for net income can be hacked, as discussed earlier, by plowing your money that could’ve been net income back into the company in order to reduce your tax liability. Because of this, a highly profitable company can have a net income of zero while still being a prudent investment, more detail on this later on in the chapter. Now, if you go the way of the academic, after you project your future cash flows, you’ll discount these using the WACC, or the weighted average cost of capital. Given that I’ve just graduated from finance school and I’m sick of hearing the academic’s perspective on the matter, I’ll spare you the details of what actually goes into the WACC, except to tell you that it is more or less academic hooey that is use to “make the high priests in academia feel smart” as Charlie Munger puts it. He couldn’t be more spot on than he is in that quote right there. With this in mind, there is absolutely a way to discount future cash flows the easy way, which is to once again project future cash flows by finding a combination of the short term and long term free cash flow growth rate, and to then take those future cash flows and discount them by the discount rate, which in Warren Buffet’s case is the risk free rate, or the rate on a U.S. Treasury Bill, which is about 2.5% to 3% right now. From there, you take that discounted number and discount it by 30-50%, and if you can find a stock that is priced that cheaply, then you’ve got yourself a winner, buy, buy and buy some more!

Why the Actively Traded Mutual Funds Give Us Perspective on Fundamental Analysis, How to Read Financial Statements on a Mutual Fund Gig, My Fundamental Analysis Review

If you look at some of the hottest mutual funds over the last century, and especially over the last decade or less, than you’ll notice that every single hedge fund and mutual fund over a long period of time lost to the S and P 500 index fund, especially when you account for fees and transactions costs (broker commissions). The majority of actively traded mutual fund managers use fundamental analysis almost solely, in order to pick out their own diversified portfolio of stocks at the beginning of each year, and then typically will let the majority of these ride out until the opening of the next year, before changing out a large chunk of these due to what has happened “based on market forces.” I’ll discuss the flaws in this logic more in a second, but first I wanted to add that the free cash flow that I talked about in the last few paragraphs has a very simple formula to it, and that is as follows:

 FCF = Cash Flow from Operations – Capital Expenditures (fancy term for the company’s expenses)

Final Thoughts on My Fundamental Analysis Review, and On How to Read Financial Statements Properly

Funny enough, there are actually two fields where fundamental analysis reviewing really plays a huge role in one’s career, and those are finance and accounting. As the saying goes, Accountants make the financial statements, while financial analysts and CFA’s review them, analyze them, and draft future projections of them. As an off topic comment about this, I hear all the time in business that accounting is backward looking while finance is forward looking, and while that saying has its merits, it is not entirely the case. What the saying should be is that Financial Accounting is backward looking, Managerial Accounting is both backward looking and forward looking, and finance is forward looking, but who the heck has the time to say that. Hope you guys enjoyed my long, 2000 word blog post on fundamental analysis, and if you enjoyed it enough, subscribe to our blog for more details and information, or comment down below with any thoughts or opinions that you may have on the article, and we will reply in kind! Until next time, thanks for reading!

 

 

Cheers!

 

 

*Inflationhedging.com

Sources:

https://finance.yahoo.com

https://money.cnn.com/data/markets/

 

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