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Four Fundamental Tests Every Stock Investor Should Use

by Michael C. Thomsett

Four Fundamental Tests Every Stock Investor Should Use Splash image

Fundamental analysis is a sensible, valuable and sound system for comparing companies and for narrowing down the list of strong candidates.

But the problem for every investor remains: Out of the range of possible indicators, which fundamental tests should you use? More to the point, how do you know you are getting an accurate picture based on the indicators you rely on to pick value investments?

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About the author

Michael C. Thomsett is author of over 70 books, including “Bloomberg Visual Guide to Candlestick Charting” (John Wiley & Sons, 2012) and “Getting Started in Options,” 8th edition (John Wiley & Sons, 2010). He lives in Nashville, Tennessee, and writes full time (www.michaelthomsett.com).
Michael C. Thomsett Profile
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Everyone has a short list of their favorite indicators. However, there are four that virtually everyone needs; for some, a list of favorite indicators does not provide the full story of a company’s financial strength or working capital trends. These four essential indicators not only make comparisons between companies easier and more revealing, they also help you study the company’s recent history of results and judge operations and working capital to ensure that the company you put on your short list belongs there.

The four tests work together to avoid a common problem: focusing on one or two important tests while deeper and perhaps growing problems go unnoticed.

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1. Revenue and Earnings

This combined study is essential and should be summarized for at least five years using dollar values as well as net profit margins (net income divided by revenues).

You want to watch out for companies whose revenues are growing while profits are shrinking—a very negative trend. The same observation applies when revenues are on the decline but net profit margin is declining more rapidly, also a big negative.

The ideal outcome is growing net profit margin, even when revenues and the dollar value of earnings are falling. Even in weak market cycles, well-managed companies should be expected to produce improving net profit margins over time.

2. Price-Earnings Ratio (P/E)

The comparison between price per share and earnings per share is an oddity in analysis because it compares a technical analysis element (price) to a fundamental analysis element (earnings). The price-earnings ratio is calculated by simply dividing the price by earnings per share. The multiple represents how many years of per share net earnings are reflected in the current stock price.

A price-earnings ratio that is too high means the stock is probably overpriced; a price-earnings ratio that is too low indicates lack of interest in the company. As a general rule, the desirable middle ground is between 10 and 25.

However, there is another problem with the price-earnings ratio. The timing of each side in the equation is not identical. Price is current but earnings per share is historical. So, the farther away from latest reported earnings, the less reliable the price-earnings ratio. For this reason, the historical price-earnings ratio becomes more meaningful when analyzed as a high-to-low range for a period of years, and not as a singular value at any one moment.

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3. Dividends per Share

You will prefer to invest in companies whose dividend is growing each year. The dividend is easily overlooked, but it represents a major factor in your overall return from investing in stock.

You can also increase dividend yield by reinvesting dividends to purchase additional partial shares; this has the effect of creating compound returns of the dividend yield (you own more shares for the same initial investment).

The best-managed companies increase dividends each year, which is also a reflection of growing profits and well-managed working capital (assets minus liabilities). The company cannot increase its dividend if it has little or no liquidity.

Seek companies that increase dividends every year over the long term. These so-called “dividend achievers” tend to be better managed than average and fall into the category of value investments more than those companies with falling or skipped dividends.

4. Debt Ratio Trend

The debt ratio (long-term debt divided by total capital, which is combined long-term debt and stockholder’s equity) can be overlooked, but it is the most important test of working capital.

The current ratio (current assets dividend by current liabilities) can be misleading, especially if the company has allowed its long-term debt to grow in order to bolster cash, accounts receivable and inventory to keep the current test steady.

Looking only at the current ratio is also a problem because it does not reveal the real trend in debt. A growing long-term debt is a big problem, because it translates to ever-higher interest and debt service in the future, and that means less capital remains for expansion or dividends.

You want to see a steady or declining debt ratio from year to year, not growing levels.

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Revenue and Earnings

The first test is a year-to-year comparison between revenue and net earnings, including the dollar value of earnings as well as the net profit margin (net income divided by revenues). This is crucial because the relative changes in net income are difficult to spot if you limit the analysis to dollar values only. For example, look at Table 1, which shows the trend in results for Target (TGT).

Year Revenue
($ Mil)
Net Income
($ Mil)
 
 
2010 65,357 2,488  
2009 64,948 2,214
2008 63,367 2,849
2007 59,490 2,787
2006 52,620 2,408
 
Year Revenue
($ Mil)
Net
Income
($ Mil)
Net
Profit Margin
(%)
2010 65,357 2,488 3.8
2009 64,948 2,214 3.4
2008 63,367 2,849 4.5
2007 59,490 2,787 4.7
2006 52,620 2,408 4.6
 

This does not look bad at all. Revenues grew each year; in fact, revenue growth was both strong and consistent. Profits did not improve as much, but overall the picture seems fair. However, when you calculate the net profit margin, the picture is quite different, as can be seen in the bottom part of Table 1.

The small bump in the latest year does not offset the fact: In spite of strong revenue growth, net income was flat and net profit margin declined during this period. You can define growth in many ways, but this complete picture of Target’s results shows that even with a 24% increase in revenues over five years, the net profit margin fell. The seemingly positive trend is actually negative.

Results for DuPont (DD)
Year Net
Revenue
($ Mil)
Net
Income
($ Mil)
 
Profit Margin
(%)
2010 32,687 3,031 9.3
2009 27,328 1,755 6.4
2008 31,836 2,007 6.3
2007 29,378 2,988 10.2
2006 27,421 3,148 11.5
 
Results for Dow Chemical (DOW)
Year Net
Revenue
($ Mil)
Net
Income
($ Mil)
 
Profit Margin
(%)
2010 53,674 2,321 4.3
2009 44,875 538 1.2
2008 57,514 579 1.0
2007 53,513 2,887 5.4
2006 49,124 3,724 7.6
 

Analysis of revenue, income and net profit margin takes on even more meaning when comparisons are made between two companies in the same industry. For example, two companies in the diversified chemicals sector are interesting when studied on their own, but even more revealing when their annual results are compared, as shown in Table 2.

Revenue and net income results for DuPont (DD) were relatively flat during the period; however, the most troubling aspect of these results is the net profit margin. Assuming that 2006 and 2007 were high points in the business cycle, the company reported higher revenue than the 2006–07 time frame during two out of the last three years, but lower profits and lower net profit margin.

Compare this to one of DuPont’s major competitors, Dow Chemical (DOW), whose results are shown in the lower half of Table 2.

Revenue levels were much higher than DuPont’s, but the net income trend was significantly lower. Even worse, net profit margin fell steadily over four of the five years—only the latest report bumped up. With the revenue levels somewhat flat from the beginning to the end of the period, it is noteworthy that the 7.6% net profit margin for 2006 declined to only 1.2% in 2009 before rebounding somewhat. Based on this test, DuPont was a much stronger company, even with its declining net profits.

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Price-Earnings Ratio (P/E)

The second test is the price-earnings ratio. This test should involve multiple-year summaries of high and low price-earnings ratios rather than the just the latest calculation. The use of a forward price-earnings ratio (based on estimates of future earnings) has become popular, but this ratio is not an accurate fundamental test. Because earnings have to be estimated, the forward price-earnings ratio is much less reliable than most fundamental investors want and need to use in their analysis.

With the general rule of thumb that the price-earnings ratio should reside between 10 and 25, both DuPont and Dow Chemical reported ranges within generally acceptable levels for the five years, with one exceptional spike for Dow, as shown in Table 3.

Year DuPont
Price-Earnings Ratio
Dow Chemical
Price-Earnings Ratio
High
(X)
Low
(X)
High
(X)
Low
(X)
2010 15 10 20 13
2009 19 8 nmf nmf
2008 24 10 70 24
2007 17 13 16 13
2006 15 11 12 9
 

The price-earning ratio range for Dow Chemical during 2008 indicates some disturbing volatility for part of the year. In 2009, net income was too low to register, a sign of volatility in the fundamentals as well as on the technical side. With these two years of results, how can you determine whether the current stock price is reasonable? For 2010, Dow Chemical’s price-earnings ratio ranged between 13 and 20, which represents a return to the acceptable mid-range level. However, Dow’s recent price-earnings ratio volatility makes it very difficult to estimate future changes on either the fundamental or technical side.

In these examples, the price-earnings ratio analysis for DuPont is reassuring, with its five-year record of consistent mid-range results. However, Dow Chemical’s price-earnings ratio range spiking in 2008 (followed by low profits in 2009, making the price-earnings ratio non-existent) is not comforting at all. In this respect, the price-earnings ratio can also provide an indication of volatility in both share price and fundamentals. Looking back at the revenue and profit analysis, it is apparent that recent activity in Dow Chemical makes it difficult to forecast ahead. For investors considering buying shares of any company, uncertainly like this is unsettling.

Dividends per Share

The third indicator everyone can use to narrow down the list of stock choices is the history of dividends per share. Dividend yield is an important portion of overall return even though you might easily forget or overlook it. The truth is that some investors treat dividends as insignificant or unimportant. This is a mistake.

It is not enough to look only at the dividends per share. A $1.00 per share dividend for a $40 stock is twice as valuable as a $1.00 per share dividend for an $80 stock, for example. You need to compare the yield, based not only on current price per share, but also on your basis in the stock for shares already in your portfolio. This is important because yield changes every time the stock price changes. The dividend yield commonly listed on stock quote pages is indicated dividend (expected dividends over the next year) divided by price.

Year DuPont
Div/Share
($)
Dow Chemical
Div/Share
($)
2010 na na
2009 1.64 0.60
2008 1.64 1.68
2007 1.52 1.64
2006 1.48 1.50
 

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For example, consider the change in yield for a stock currently priced at $50 per share that you bought at $35 per share. The dividend payment is $1.00 per year. Your observed dividend yield was 2.9% ($1/$35) even though current dividend yield is only 2.0% ($1/$50). This is true because you realize the yield based on your purchase price and not on current price per share. Your true yield is most accurate when calculated on this basis. However, for shares of stock you do not yet own, dividends per share and dividend yield are important comparative tests. In the case of DuPont and Dow Chemical, five years of dividends per share are shown in Table 4.

Based solely on the record of dividends per share, the DuPont record is positive. Its dividend increased even while net income and net profit margin both fell. (Dividend data for the most recent year was not available as of publication date.) As satisfying as it is to receive higher dividends, what are the consequences of paying a higher dividend every year while profits fall? The next indicator, the debt ratio, provides an answer to this troubling question.

Dow Chemical increased its dividend for the first three out of the five years and in 2009 cut back (2010 is not yet known). Stockholders invariably view this as a strong negative; however, like DuPont, Dow experienced greatly reduced net income and net profit margin. Cutting the dividend might have been the most prudent decision based on poor results in operations.

The dividend yield itself varies with ever-changing stock prices. As of mid-August 2010, the yield for DuPont was about 4%, an exceptionally good dividend yield. At the same time, Dow Chemical’s dividend yield was about 2.4%. So strictly on the basis of dividend yield, DuPont was more attractive based on outdated but available data.

However, this analysis is not complete without also considering the trend in the debt ratio. In a sense, comparing dividend yield during periods of falling earnings with the debt ratio trend is an important form of reading between the lines of the fundamental trend.

Debt Ratio Trend

To some analysts, the ratio of long-term debt to total capital is esoteric and far in the future and thus of little immediate interest. They may believe it does not apply to the rather immediate concern of working capital strength (the extent to which current assets exceed current liabilities), meaning they can ignore the debt ratio without consequence. However, the debt ratio is not esoteric at all; it is one of the most reliable trend indicators concerning working capital. If the level of long-term debt increases each year, it is very negative. This means the future profits have to go increasingly to debt service and less to dividends or expansion.

Analysts may be able to explain increasing dividends during times of declining profits by also looking at the company’s decision to acquire more long-term debt. Contrary to the belief that bigger dividends are always better, it may be much wiser in weak economic conditions to cut back the dividend and hold the long-term debt level stable.

Another motive for accumulating more long-term debt is to keep the current ratio artificially high. If a company is losing money, or if its expenses outpace the increases in revenues, internal management may be poor. If the current ratio (current assets divided by current liabilities) remains at “acceptable” levels (usually 1.0 or higher, but this varies by industry) in such times, check the levels of current assets. If debts are rising but the company is simply increasing its current assets to match growing current liabilities, the current ratio is meaningless.

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An example of this problem can be seen in the debt ratio and current ratio figures for both DuPont and Dow Chemical in Table 5.

These results are revealing. If you study only the current ratios, the favorite standard for working capital, you would conclude that both companies are doing a fine job of keeping liquidity mostly at exceptional levels, evidenced by ratios of 1.5 or higher and rising, even while profits fell throughout the entire period. That fact betrays the apparent working capital health.

Year Dupont Dow Chemical
Debt
Ratio
(%)
Current
Ratio
(X)
Debt
Ratio
(%)
Current
Ratio
(X)
2010 51.0 2.0 45.0 1.7
2009 55.5 1.8 46.3 1.5
2008 49.8 1.6 35.2 1.2
2007 32.5 1.5 25.9 1.5
2006 37.2 1.6 29.3 1.6
 

If the analysis includes both the current ratio and the debt ratio, the true picture emerges. Both companies allowed their long-term debt to grow during the five-year period, along with corresponding growth in the year-end levels of current assets. There is nothing fraudulent about this; in fact, GAAP rules acknowledge that corporations have every right to make decisions concerning appropriate levels of debt, both current and long-term, without criticism and without the need for disclosure beyond the passive annual statement explanations. This means that a true test of working capital cannot be restricted to the current ratio; it is more accurate to study the long-term debt trend as well and to track how both the debt ratio and current ratio evolve over several years. This gives you the true picture.

When you see profits declining each year but the current ratio remaining strong and consistent, something is wrong. The two trends are contradictory. The answer is, invariably, that long-term debt is growing to offset declining profitability each year.

Putting It All Together

Indicators and trends are the lifeblood of fundamental analysis. However, two realities have to come into the analysis in order to ensure accuracy:

You cannot study any single indicator by itself; the trend is what really counts. You need at least three to five fiscal years of study to spot a trend, and the longer the period, the better. You need to watch the trend and summarize the dollars-only results in percentage terms to grasp how matters are evolving. For example, you will understand the net income trend most completely when you reduce it to net profit margin percentage result (net income divided by revenue). The same is true for all fundamental indicators. Percentages and ratios reduce dollar values to easily tracked and comprehended trends.

Trends take on accuracy when you review related indicators at the same time. If you look only at the annual trend in revenue (without also tracking earnings), or only the current ratio (without also following the debt ratio), you do not get the full story. You need to find related indicators and track them together as parts of a larger picture. The four major indicators explained here give you good examples of this. Although they approach the analysis of capital and earnings strength from different points of view, they provide you with essential insights into the trend a company is undergoing.

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A combined study of revenues and earnings, the price-earnings ratio, dividends, and the debt ratio trend paints an accurate picture of the companies you are tracking. By watching all of these trends over a period of years, you can spot those companies that are consistently outperforming their competitors. Of equal value, you can also spot gradual changes in the trends. For example, had investors in General Motors (GM) been tracking these four trends over time, they would have been able to see a declining profile and get out years before the stock price collapsed. Before General Motors was liquidated, its debt ratio was over 100% (meaning debt was higher than total stockholder’s equity), but the current ratio for 2005 was 2.9—not bad on the surface.

This was but one example of the current ratio failing to reveal the truth about a company’s status. A more comprehensive analysis is essential to reveal the entire truth about operating trends and working capital.

The traditional indicators—often reported in isolation rather than as part of a trend—may satisfy the need among investors for an endless supply of good news, but anyone who wants the full truth will want to dig deeper and look at the entire picture.

Michael C. Thomsett is author of over 70 books, including “Bloomberg Visual Guide to Candlestick Charting” (John Wiley & Sons, 2012) and “Getting Started in Options,” 8th edition (John Wiley & Sons, 2010). He lives in Nashville, Tennessee, and writes full time (www.michaelthomsett.com).


Discussion

Richard from Hawaii posted over 3 years ago:

Great article, AAII. Extremely valuable and very educational.

I love you, AAII. :)

Aloha,
Rick


New Investor from California posted over 3 years ago:

I am new to this. What is a good place to find all the information mentioned in this article - historical debt ratio, current ratio. The AAII stock charts did not show those.


Istvan from Massachusetts posted over 3 years ago:

very revealing! Iwould like to make it one of my investment tools. Where is an easily accessible data base where I can find the historical data needefor the analyses?


Kirk from Pennsylvania posted over 3 years ago:

@Amlan and Istvan: I don't know if there is any publicly accessible data. AAII has a "Stock Investor Pro" for $198/year that will give you 10 years worth of all kinds of data. Otherwise, you will have to do your own calculations company by company. I'd be interested to know if there are other alternatives.


Charles Rotblut from Illinois posted over 3 years ago:

Hi Alman,

Much of the data can be found by calling up a stock quote and then clicking on financials on AAII.com. For example, information on DuPont is avaialble at:
http://www.aaii.com/quote?qm_page=53007

More detailed information is available on our Stock Investor Pro program:
http://www.aaii.com/stock-investor-pro/


Richard from Kentucky posted over 3 years ago:

Very interesting! I joined AAII hoping it would help me make wise investment choices. The information appears to be here but the data I need to make a decision isn't. That is unless I purchase your investor-pro for $198.00. Typical con job. I can't believe I was this stupid. Bet this email doesn't stay or your website. Thank You,
Richard from Kentucky


Britni from California posted over 3 years ago:

This article:
http://www.aaii.com/computerized-investing/article/the-top-web-based-stock-screening-services
points to other data sources. I don't know if you need to subscribe to CI to get to the article.

Easy on the conspiracy theories. I've been with AAII 20 years and no one's out to screw anyone--just the financial industry, investment banks & the billionaire lobbies ;-)


Darryl from Louisiana posted over 3 years ago:

Richard: Sorry, but you are incorrect. I never puchased a stock in my 51 years until 2 1/2 months ago. I purchased SI pro, studied it, started research and started buying. I'm up over $1000. It would be a lot more if I had paid better attention to some of the information available. I really don't want to sound flippant, but if you want to be cheap, you can do things the hard way if you wish... Good luck!


Sandra from California posted over 3 years ago:

A lot of free info can be found on Morningstar website, including ten year stock information. To obtain analyst reports and some other info requires subscribing.


Ken from Alabama posted over 2 years ago:

Financial info is available from a variety of pay sources e.g Morningstar, WSJ, etc. But there are free reference sources available at your local public lib


Barb & doug from Washington posted over 2 years ago:

This article was very informative. I'm in the process of taking control of my portfolio from a broker. Thanks for helping me get "up to speed". Doug


Joseph from Massachusetts posted over 2 years ago:

fantastic article. i had the same question - where to get this data that is neatly summarized here. Thanks for all those tips. i am starting to reapportion part of my IRA to probably use the Shadow portfolio. I want to better understand the philosophy - this article really helps. thanks.
p.s. i am new member who wishes I had paid more attention when I first investigated aaii 10 years ago.


Dale from Utah posted over 2 years ago:

when will investor-pro be mac friendly


Roger from Florida posted over 2 years ago:

"A price-earnings ratio that is too high means the stock is probably overpriced."
Other than "too high" is subjective, a P/E over the stated 25 high may well mean that the stock is performing well in the eyes (pocketbooks?) of investors. P/E is almost a meaningless criterion for investing. A P/E over 25 may be an indicator of a volatile (momentum) stock, but it also can lead to great profits from capital appreciation (there are many, many examples); they just need to be monitored closely.


Daniel from Illinois posted over 2 years ago:

I asked aaii a few weeks ago about the Mac and this is what they replied:
Stock Investor Pro is a Windows-based program. You can run on the Mactel-based systems running Windows on utilities such as Bootcamp and Parallels.

I have considered getting one of these emulators to allow me to get Pro but just want to be sure the $199/year is worth it. Based on the above comments, my position is strengthening.


Mark from Alaska posted over 2 years ago:

For the next investor conference how about sectionals on using various selections from the AAII web site? Also to the fellow who was disappointed with his membership, I have always thought of AAII membership as a source of information, not to be told what vehicle to invest. I do however, wonder why Mac users are not "allowed into the secret inner sanctum of Computer Investing". Thanks AAII for providing great information to me since 1989. I can't remember but CI might have been available back then on a CD......out


Charles from New York posted over 2 years ago:

Your article was great. The problem I have as a new AAII member is where exactly do you find some of the data to evaluate a stock?? For example, if I were looking at XOM as a possible buy, where would I find Price/Book and Price/Sales ratios??


Charles from Illinois posted over 2 years ago:

Charles-If you go to the home page of AAII.com, you will see a box to call up stock quote right below the "Today's Market" chart. Type in the ticker, hit go and you will be directed to the quote page. On that page, click on "company" and then "key ratios". -Charles Rotblut, AAII


Steven from Iowa posted over 2 years ago:

This is a very good article. 15 years ago when I was just getting started I bought Dell Computer because I once knew a girl named Della. And Southwest Airlines as their ticker is 'LUV'. My returns were so great that my broker highlighted my profits with parenthesis. I am a micro-micro investor, too poor now to pay for the premium services. But with the help of being a basic AAII member and reading all the free articles on the internet - many of the sites pointed out by AAII - I am getting better. Now I know what P/E is. Some one may promote a stock and I can analyze their argument. Perhaps see through their smoke cloud. Sometimes. It takes lots and lots of work and a long long time.


Robert from Florida posted over 2 years ago:

Where do you find annual hi-lo P/Es?


Thomas from Minnesota posted about 1 year ago:

Stock Investor Pro and the Macintosh.

As a long time Mac user I have evaluated several Windows emulators over the years. My pick is Oracle's VM VirtualBox. The price is right,it's a free download from https://www.virtualbox.org/

My iMac with OSX 10.6.8 running Windows 7 on VirtualBox is giving me a completely satisfactory user experience.

Since Stock Investor Pro comes with a 3-month money back guarantee it download it to VirtualBox and give it a try.


Glen from California posted 10 months ago:

What help are the questions without the answers??


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