Fundamental Analysis – Stock Market Trading – The Ultimate Beginners Guide
In this module I will discuss the financial or fundamental attributes of any particular company which I feel you should review to both evaluate and compare any company which you are considering adding to your Investment portfolio.
This blog will give you EVERYTHING you need to make informed and sensible decision on what stocks to buy and what stocks to avoid.
I recommend each investor attempt to design a stock portfolio which is diversified across industries. See more in depth discussion of portfolio design in one of my other blogs. One should aim to invest in multiple companies across multiple industries. So we will need to identify several top quality companies.
My Stock Evaluation model will help you decide which companies you are more comfortable owning. The model is essentially a rating and filtering tool and will help you select only the best companies for your portfolio. Essentially the price of a company’s share price is driven by expectations of its future earnings performance. When expectations of future sales and earnings performance are rising the share price generally will rise and vice versa. In the long run it’s all about the fundamentals!
I will present you with a user friendly excel based Company Evaluation model which should be completed before you invest in any company. This model requires you to research a specific number of financial characteristics of the company and will award certain scores for each result. Don’t worry ! Ill show you exactly where to look this information up for free.
A Great Company at a Great Price
This will serve two purposes. Firstly, you will determine whether the company is a good quality company. Secondly, you will determine whether the company’s share price represents good value for money, i.e. is the share price too high or not. Our Alpha Evaluation model will allow you to grade each company using a straightforward systematic and consistent approach.
This is an essential starting point. So lets get started !
How Do Your perform a fundamental analysis of a stock
My model is Excel based, i.e. it is a user friendly spreadsheet based evaluation tool developed by me and my staff. You can download it from my website for free. I always begin with the fundamental analysis before making any investment. I strongly recommend you do likewise.
What ARe the Components of Fundamental Analysis
The goal of fundamental analysis is to determine the performance and the overall health of a company or security. Through fundamental analysis, investors aim to identify strong companies and industries as well as fundamentally weak ones. Following the analysis, investors generally make long bets on strong names and short bests on weak ones.
Fundamental analysis often aims to provide answers to some of these questions:
- Is a company’s revenue growing?
- Is the company making a profit?
- Does the company compare favorably with its competitors?
- Can the company successfully repay its debts?
- Are there any questionable financial practices taking place among the company management?
When putting together fundamental analysis for a company, it is often helpful to look at that company’s financial statements, overall health and historical performance, and broader factors such as the company’s competitors and the industry or even the economy as a whole. The ultimate goal of the process is to determine whether or not the company is a good investment, both now and into the future.
Fundamental analysis can also be used to measure the state of futures and forex products. In this case, an analyst might focus on factors like interest rates, earnings, employment, housing, production, GDP, and manufacturing rates. On the other hand, fundamental analysis of a bond might include consideration of interest rates, the general state of the economy, and data concerning the bond issuer, such as credit ratings.
When applied rigorously and thoroughly, fundamental analysis can provide an excellent view of the true value of a potential investment. The key, then, is knowing which factors to include in a consideration, and securing all of the information in a timely fashion in order to best be able to capitalize on any investment opportunities.
Qualitative Trading – The ten questions you need to know before you buy stock in a company
There are ten questions each for both Quality (Q1 through to Q10) and Value for money (V1 through to V10). Each question has a sliding scale for which we award points. We will award companies marks for each piece of information reviewed.
In all cases when a company only earns the minimum points score it should be considered as a warning or an important note of caution on the stock.
The maximum score is 100. I award scores out of 100 for both Quality and Value for Money.
The highest scoring companies are graded “A” for Quality and “A” for Value for Money. Consequently we would ideally design our portfolio around such companies when possible.
It should be noted that each investor is likely to have different risk tolerance levels and hence different scores will be acceptable to each investor. Only you can answer which is suited to your risk tolerance level. On a simplistic level the highest scoring companies will suit the lowest risk tolerance investors more than lower scoring companies.
The model is not intended to be a virtual crystal ball but it is a most useful tool to help you identify and select high quality companies at reasonable prices.
So what is Fundamental Analysis and how does it help Investors?
Fundamental analysis is a form of investment analysis which focuses on a company’s financial statements, sales (or revenues), earnings and the management team. Financial statements include a Profit & Loss account (sales and earnings or income), a Balance Sheet (assets and liabilities) and a Cash Flow statement. Please stop yawning!
I strongly urge you to read the quarterly earnings press releases for each company either in your current portfolio or under consideration for an investment. This will give you detailed information on the change in sales, costs, assets and debts from one period to another. For example, many companies report the split of their sale or revenue by geographic region.
This can be significant especially in times when one region in the world may be heading towards a recession. If your stock for example generates a high proportion of its sales in that region then it will become more difficult for your company to grow. This will impact the share price.
You will often hear analysts refer to quantitative analysis. This is basically the figures or the financials of a company. This information is available to everyone. Hence you would imagine that it would give no advantage to an investor to review such information.
However, I can assure you based on my own investment experience that the market often undervalues and often overvalues a company at any point in time. This is due mainly to the emotions of traders. When the market sentiment turns strongly against a company you can find its share price drop to remarkably low prices.
The opposite is true of course. When the market sentiment becomes over enthusiastic about a particular company the share price can rise much faster and higher than expected or warranted. Recall the Nasdaq bubble or the ‘dot com’ bubble.
This happens because the market generally moves based on traders evaluating the future prospects of a company. Hence, sometimes unrealistic expectations are built into the share price. The share price tends to correct however and this usually occurs once the company reports its quarterly earnings.
Future Expectations – A key part to Fundamental Analysis Investing
That is a key part of fundamental analysis. It is not sufficient to simply review historical data. An investor must keep abreast of breaking news and the latest earnings reports paying particular attention to the future earnings and sales guidance. Management of public companies provide valuable insight into the key factors impacting the company on the quarterly earnings conference call. These reports provide the investor with critical insight on the near term future of the company.
This will impact the share price either positively or negatively. Remember we spoke at the start of this module about the expectations for future earnings potential. The news releases are studied by the market and then the share price reacts although sometimes it overreacts.
Company News Releases are vital for the informed Fundamental Analysis Investor
I refer to news releases on a company as the ‘heartbeat’ of a company. For example, a large cap drug company stock price can suddenly become steady once it secures its patent protection for a key product. This would result in much steadier and secure earnings for that stock over the short term at least. This should then secure the stock price ceteris paribus (i.e. all other things remaining equal).
This area of research is often referred to as qualitative research. This is much more subjective and as such investors will often differ in opinion on the fundamental prospects for the company performance in the future. This results in share price movement.
It must be noted that share prices can fluctuate based on non company specific news and fundamental data also. For example, during the Financial Crisis of 2008 almost all stock prices fell sharply. Both good and poor quality companies found their stock prices falling. The market was in a panic mode (often referred to as the “market rollercoaster”).
However, extreme reactions like this occur in the market frequently. To this end we find it highly valuable to have your homework done and have your key stocks identified and monitored so that when an attractive share price presents itself you are actually ready to step in to the market and buy, i.e. to make an investment.
Fundamental Analysis PART 1: QUALITY REVIEW (Q)
Our first objective using our company evaluation model is to determine whether or not the company we are considering for an investment is a good or high quality company. I do not recommend investing in poor quality companies.
I highly recommend Value Line as a source of information and projections. The main reasons are twofold. Firstly their research is conducted by independent and unbiased researchers. Too often we notice biased or conflicted analysts with connections to large trading houses announce certain BUY or SELL recommendations on stocks at almost exactly the wrong time. Hence we tend to treat such analyst comments with guarded interest.
It is not that we ignore such analysis but we rarely open a trade based on such an analysts breaking view. We would however take on board their rationale and monitor how the share price performs in the aftermath. Often a better price presents itself on that stock in the future and if we agree with the analysts rationale for a buy rating and having passed the company fundamentals through our own company evaluation model then we can confidently make the investment.
Secondly, the performance of share prices of companies awarded top scores on the Value Line proprietary ranking system have significantly outperformed the market indices average performance over long periods. We will explain this in much more detail later in this module.
2.1. Independent Research Resource – Value Line
Value Line information is available on the website www.valueline.com, and an example of a Value Line report for the company Microsoft is included with this blog. You can subscribe directly to Value Line yourself or you can avail of a special offer discounted rate by joining through my website.
Let’s provide you with an overview of what the Value Line research centre provides to investors.
Value Line – The Key to Fundamental Analysis for Stock Investors
Value Line conducts reviews on approximately 1,700 stocks. These account for almost 95% of the market capitalisation of stocks which trade on the US stock exchanges. Value Line has been offering its services since 1931. Every three months Value Line issues a one page report on each of the companies. This report will take the format of that in Fig 1.6 below. This report includes actual financial data reported, projections on financial data and Value Line proprietary ranking scores.
Value Line provides a ranking system for stocks. The rank represents a score relative to the other stocks covered by Value Line. The rank scores work on the basis that the top ranked companies are awarded a rank of 1 while the lowest ranked companies are awarded a score of 5. The ranking scores are the result of Value Line feeding in many specific details on a company into computer based program which is a proprietary program. All we need to know is the score however as the results of the ranks of the highest scoring stocks give us the confidence to use the information (see below).
A full and more detailed explanation of all the Value Line research is available on the Valueline.com website under “Investment Education”.
The key rank categories we pay close attention to are Timeliness and Safety.
My model to determine whether or not a company is a quality company involves consideration of ten questions which are set out below. These questions involve awarding the company various scores based on the answers to the questions. The maximum overall score is 100 points for the set of the ten questions.
Remember we wish to identify good quality companies at the right price. We will consider value for money or price in the second set of ten questions.
Excel-Based Evaluation Model for Fundamental Analysis
Tip 1: If you use our complimentary Excel based evaluation model you will conduct your evaluation much faster than using the paper version.
Tip 2: If using the excel model then once you have downloaded your Value Line one page research sheet please proceed to the “Value Line Data Input” section of the model which is located on the Quality Tab at the top right hand side.
When you input these figures many of the questions which follow will automatically be answered for you and the appropriate score awarded to the company!
Please see my help sheet (at the end of this blog) which shows where all the answers to the various questions are to be located on your one page Value Line report.
Fig 1.1 See below screen shot for the input section for Microsoft (ticker MSFT). The boxes shaded blue require data input.
Tip 3: as you progress down through the spreadsheet model you will encounter various boxes highlighted in blue. These require some piece of data to be entered. If the data required has already been entered on the Data Input section above the data will automatically be input for you.
Let’s take each question in turn and provide a brief description of the information required, where to find that information and why we look at each piece of information.
Our first category on Quality evaluation is Timeliness.
Quality Q1 – Timeliness Rank
The Value Line Timeliness rank score has been used since 1965 and is their most famous rank score along with Safety rank. Only 100 of the 1,700 stocks covered can be awarded the top rank of 1 for Timeliness. Statistical research on the share price performance of stocks with the Timeliness rank of 1 is most impressive. See attached Value Line booklet.
If an investor had only ever held investments in stocks with a timeliness rank of 1 from 1965 through to 2009 the cumulative return over the period would have amounted to 26,533%. A summary of each rank is as follows:
- Timeliness rank 1 stocks performance was a cumulative return of 26,533% (Top 100 stocks)
- Timeliness rank 2 stocks performance was a cumulative return of 3,472% (Next 300)
- Timeliness rank 3 stocks performance was a cumulative return of 184% (Next 900)
- Timeliness rank 4 stocks performance was a cumulative return of -71% (Next 300)
- Timeliness rank 5 stocks performance was a cumulative return of -99% (Bottom 100)
The above table is self evident in illustrating why I consider this rank data to be a critical part of an investor’s research. An important point to note is the Top ranked stocks also tend to fall less in periods of extreme market declines.
The Timeliness rank is defined as the probable price performance of a stock relative to the other 1,700 stocks covered by Value Line over the next 6-12 months. Timeliness Rank 1 stocks are expected to be the best performers in price. Rank 2 are the next best group and are expected to have above average price performance. Rank 3 stocks are only expected to show average price performance.
Rank 4 stocks are expected to show below average and rank 5 are expected to have the poorest relative price performance. Stocks ranked 1 and 2 are not expected to outperform the market in every single week or month but the result indicate they are expected to outperform over longer time periods.
A few points to note on rank scores. Rank scores are reviewed and updated if necessary on a weekly basis. Rank score can change for example following a new earnings report or a change in share price relative to the other stocks covered. So please keep an eye on your stocks rank score each week!
The results are significantly different as you move away from the top ranked timeliness stocks and that is why we place this Timeliness rank score as our very first piece of information to extract and enter into my company Evaluation model. There is no need to reinvent the wheel folks. If you find something that works then why not use it?
Note: Be aware that Timeliness rank 1 stocks tend to be smaller companies and are often more volatile. Conservative investors may wish to balance high rank timeliness stocks with high rank safety stocks which tend to be more stable.
In my model I award a score for each piece of information we review.
The company Timeliness rank is available at the top left hand corner of your Quarterly Value Line one pager report. However, this can be as old as three months. I recommend you use the latest timeliness score by referring to the Value Line website and entering the “Summary & Index” reports which are published online each week.
I always try to use the most up-to-date information available.
The scores we will award for company specific timeliness are as follows:
|Timeliness Rank of 1 is Ideal so we award 5 points|
|Timeliness Rank of 2 – we award 4 points|
|Timeliness Rank of 3 – we award 3 points|
|Timeliness Rank of 4 – we award 2 points|
|Timeliness Rank of 5 – we award 1 point|
Note: Timeliness ranks are only available for stocks with two years of trading history. Sometimes stocks you research will show no Timeliness score for example when they are subject to an impending takeover or merger. For example BBY received a takeover bid in August 2012 and Value Line now indicates a Timeliness score of “NMF” (no meaningful figure).
Our second question on Quality review is Q2 Industry Rank.
Quality Q2 – Industry Rank – Fundamental Analysis
Industry rank is essentially simply an average of the timeliness ranks for all the companies within a particular industry. Value Line groups the 1,700 stocks into approximately 100 separate industries.
We want to own stocks which have the highest probability for us to earn an attractive return on. It is an advantage if we own a company with a high timeliness rank which also belongs to an industry with a high rank as it means we are investing in an area with a tailwind which is generally safer and more rewarding than investing in industries with headwinds. Such industries can see stocks suffer serious price drops in short time periods and be reluctant to recovery for long periods.
How to find Rank on Value Line Website
Like timeliness of individual stocks the industry rank is updated weekly. When you enter Value Line simply click on “Research Hub”, then click “Investment Survey”, then click “Lookup Company” and select “Search” to see the Industry for this company. Then Click “Lookup Industry” and scroll down the list to find the industry for your company. The industry rank will show beside each industry.
Value Line provides a very useful overview of each Industry under the “Industry Report” acrobat pdf file which shows on the screen beside Industry Rank (as found above). I encourage you to read the industry report. It will quickly point out whether the company is one which is growing or declining.
The Industry report will also point out significant issues for particular industries. It will also allow you to compare the company you considering for an investment to the industry.
For example, is the company you are considering earning a profit margin greater or less than the industry average? How about growth projections for the company compared to the industry average? Favourable industry trends make for favourable movement in the share price of companies within that industry.
These comparisons represent important further reading and analysis to complement our Alpha evaluation model. If a company’s margins and returns are above the industry average then the company is probably efficiently run. If the opposite is true then the company is likely not efficiently operated and hence could likely be run better.
However, many industries are dominated by one or two companies. In these cases comparisons to the industry averages may not be meaningful. For example Dow Chemical and DuPont account for 80% of the sales of Value Line industry Basic Chemicals.
The scores we will award for Industry timeliness ranks are as follows:
|Industry Timeliness Rank between 1 and 20 is Ideal so we award 5 points|
|Industry Timeliness Rank between 21 and 40 – we award 4 points|
|Industry Timeliness Rank between 41 and 60 – we award 3 points|
|Industry Timeliness Rank between 61 and 80 – we award 2 points|
|Industry Timeliness Rank between 81 and 100 – we award 1 point|
Our third question on Quality review is Q3 Safety Rank.
Quality Q3 – Safety Rank – Fundamental Analysis Guide
Value Line’s safety rank measures the total risk of a stock relative to the other 1,700 stocks. This uses details on the stock’s price stability and financial strength. You can find these scores on your Quarterly one page report.
Stocks with high ranks for safety tend to be larger companies with strong balance sheets and stable businesses. They tend to be slower growing companies.
Stock price stability is calculated using the weekly percentage movement in the share price of a stock over the past five years. The more stable stocks have higher scores for price stability.
The high rank safety stocks are particularly useful for those who wish to remain invested but fear a market decline in the short term. These stocks tend to decline much less than others in general market declines.
One thought for those wishing to design balanced portfolios is to decide on a suitable mix between high timeliness ranks 1 & 2 and high Safety 1 & 2 stocks. Remember high Timeliness stocks tend to be expected to grow fast in the short term and hence would typically not include high safety stocks which are expected to see slow growth. For a more in depth analysis of portfolio design please refer to Module 6 on Portfolio Allocation and Capital Protection.
Unlike timeliness rank the safety ranks do not have fixed numbers of stocks with each rank. The safety rank for each stock is found at the top left hand corner of the one page quarterly Value Line report.
The scores we award in Q3 for Safety ranks are as follows:
|Safety Rank of 1 is Ideal so we award 5 points|
|Safety Rank of 2 – we award 4 points|
|Safety Rank of 3 – we award 3 points|
|Safety Rank of 4 – we award 2 points|
|Safety Rank of 5 – we award 1 point|
Our fourth question on the Quality review is Q4 Debt.
Quality Q4 – Debt – Fundamental Analysis Guide
It should be obvious to all that an investor would generally prefer the company debt to be lower rather than higher. High debt levels restrict a company’s range of actions especially in downturns. Debt repayments reduce the share of earnings available to shareholders. This is not a problem when the company is growing as long as the debt allows the company to increase the returns on shareholder equity.
Some companies by their nature tend to have larger debt loads due to high capital investment requirements in advance of earnings. For example, oil companies, telecom companies, gold and coal mining companies etc.
Lower debt companies can be more flexible. They can take advantage of extreme market declines for instance and can increase debt for example at such opportune times to say acquire low priced companies. Just like individual investors try to BUY LOW and SELL HIGH.
Also, companies with high debt burdens can struggle during recessions as sales and earnings come under pressure. This can be a source of risk for these companies just as is the case for individuals with high debt levels. For this reason we score companies with high debt levels lower than those with lower debts.
We measure debt by simply expressing total debt as a % of the company’s market capitalisation. Both figures are shown on the Value Line one page report on the left hand side under “Capital Structure”.
Sometimes Value line reports Total Debt in millions. To convert this figure into billions simply divide by 1,000. Our ratio is based on billions of debt divided by billions of market capitalisation.
Regarding market capitalisation this figure obviously changes as the share price changes. Hence, on our model we prefer to use the current market price and multiply this by the number of shares outstanding as per the latest Value Line report to derive the current market capitalisation. Again we state the value in billions so be careful in your calculations.
To express the ratio as a percentage simply divide your debt by your market capitalisation figure and then multiply by 100. Remember our excel model does these calculations for you to make your research less time consuming!
The scores we award in Q4 for Debt levels are as follows:
|Debt as % of Market Cap less than 15% – award 5 points|
|Debt as % of Market Cap between 15% – 35% – award 4 points|
|Debt as % of Market Cap between 35% – 60% – award 2 points|
|Debt as % of Market Cap above 60% – award 1 point|
Our fifth question on the Quality review is Q5 Financial Strength.
Quality Q5 – Financial Strength – Fundamental Analysis Guide
The Value Line Financial Strength rating is available on the bottom right hand corner of the quarterly one page Value Line report. The ratings are highest for “A” rated stocks declining then to B and C ratings. There are nine steps down from the highest rating “A++” to the lowest rating “C”.
Financial strength ratings are calculated using many factors used by credit ratings agencies. These include for example net income, cash flow, debt, earnings projections and patent expirations. The largest companies with the strongest balance sheets tend to get the highest ratings here.
The scores we award in Q5 for Financial Strength are as follows:
|A++ is the ideal rating – award 5 points|
|A to A+ is awarded 4 points|
|B ratings award 2.5 points (includes B, B+ or B++)|
|C rated stocks – award 1 point (includes C, C+ or C++)|
Note: Conservative investors are advised as a rule of thumb to consider ratings of at least B.
Our sixth question on the Quality review is Q6 Beta.
Quality Q6 – Beta – Fundamental Analysis Guide
Beta is a measure of volatility. It reflects the historical sensitivity of the share price to overall movements in the market index. The overall market index has a beta of 1.00.
A stock Beta of 1.20 indicates the share price of this stock tends to move rise or fall 20% more than the market.
The Beta score for a company is located at the top left corner of the Value Line one page report.
Our model caters for two broad categories of investors. Growth investors are more risk tolerant and they will prefer higher beta names. Conservative investors prefer lower beta stocks. Our model has been designed so that you can indicate your preference and then the score for the beta is based on your particular preference.
If you have a Growth bias then you should enter “Y” into the box next to “Growth” and enter “N” into the “Conservative” box.
This means you will award a stock the following points for the various ranges of beta:
|Rule 1: Beta within the range 0.95-1.1 is Ideal so award 5 points. For example a beta of 1.00.|
|Rule 2: If beta does not fit into rule 1 but the Beta metric is within the range 0.90-1.2 award 3 points. For example a Beta of 1.15 or a beta of .92 would get 3 points.|
|Rule 3: Beta outside these ranges gets 1 point|
Note: Points are awarded on the basis of the first rule which is met starting with Rule 1. For example, a beta of 1.00 would fit into both Rules 1 & 2, however, we award marks based on the first rule which is met which is Rule 1. Always start with Rule 1 and work your way down.
Growth investors want to see rapid price movements within short time spans. They do not have the patience for slow and steady stocks. As is their nature, high beta stocks can move down very quickly as well as moving up very quickly.
However, if an investor believes the market is about to rally then he/she will likely prefer to invest in higher beta stocks.
If you have a Conservative bias then you should enter “Y” into the box next to “Conservative” and enter “N” in the Growth box.
This means you will award a stock the following points for the various ranges of beta:
|Beta less than 0.90 is ideal so award 5 points|
|Beta within the range 0.90-1.05 award 3 points|
|Beta above 1.05 award 1 point|
Conservative investors do not want to see their stock prices rise and fall very fast within short time periods. They prefer slow and steady. If and investor feels the stock market has gone up too high and may possibly fall then he/she will prefer lower beta stocks as these typically are more stable or fall less than the overall market.
Our next question on the Quality review is Q7 Growth Rates.
Quality Q7 – Growth Rates – Fundamental Analysis Guide
When we review growth rates we focus on per share data for sales (revenue), earnings and cash flow. Note: Cash flow is defined in Value Line analysis as earnings (net income) plus depreciation plus amortisation less preferred dividends.
We consider the past performance and the projected performance over the next 3-5 years. We award more marks for the future performance as the share price is driven by future expectations more so than by historic performance. See Nokia (NOK) and Research in Motion (RIMM). This section of the quality review has the highest marks to be gained or lost.
All the growth rates for the past five years and the projected 3-5 years are located on your one page quarterly value line report. They are located in a box along the left hand side with the heading “Annual Rates of Change”. This indicates growth rates for revenues (Q7a) and earnings (Q7b)
Note: With respect to earnings Value Line reports earnings data excluding exceptional non-recurring charges. This is an attempt to report core or normal earnings. Hence, the figures may not match the company press releases.
Firstly let’s review the performance in sales (revenues) and earnings over the past five years. The following rates of growth are awarded the various points as per below:
|Past 5 years average annual growth rate >15% is Ideal – points 4|
|Past 5 years average annual growth rate between 10 to 14.99% – points 3|
|Past 5 years average annual growth rate between 5 to 9.99% – points 2|
|Past 5 years average annual growth rate less than 5% – 1 point|
Note: If the Value Line report for any figure is shown as “NMF” being no meaningful figure then simply enter the figure onto the Alpha model input sheet as zero or 0%.
Now we move on to the projected average annual growth rates for the next 3 to 5 year period. Here we review sales, earnings and cash flow.
We award marks slightly differently depending on the size of the company in terms of revenues. We expect smaller companies to be able to raise sales at a faster rate and hence set the bar a little higher for them.
See the table below in Fig 1.2:
|Projected Sales ($m)|
|e.g. $58,500m||Ideal (5)||HighRange(3)||LowRange(2)||RedFlag(1)|
|Small less than $500m||15%+||13.6-14.9||12.1-13.5||12 or less|
|Medium $500-$3999m||12%+||11.1-11.9||10.1-11.0||10 or less|
|Large $4000m+||10%+||8.6-9.9||7.1-8.5||7 or less|
If sales are less than $500m we treat the company as small. Hence we use the ‘small’ row to determine the scores for the various growth rates for each of sales, earnings and cash flow. The projected sales figure is located on Value Line’s one page report in a column to the far right hand side.
For example, a small company which is projected to deliver less than 12%, say 10% growth will only be awarded 1 point and so on. However, a large company (i.e. sales over $4,000m or $4b) would earn 5 points with projected 10% growth rates.
The final section under Q7 reviews the consistency of earnings, sales and cash flow per share growth over the past five years. Ideally all have grown each year over the past five years. See how we award points in our model below:
|5 Consecutive years of uninterrupted growth – Ideal so award 5 points|
|4 Years of growth and|
|Growth over the last 2 years – award 3 points|
|No growth in last 2 years – award 2 points|
|2 or more years without growth – Warning – 1 point only|
Finally for Q7 Growth we add up all the various points and award an overall point score based on the following categories:
|30-38 is Ideal – award overall 6 points|
|24-30 – award overall 4 points|
|15-23 – award overall 2 points|
|0-14 – award overall 1 point only|
NB: If you decide to invest in a company which scores a low mark on growth then please beware we strongly advise you do not invest unless you are prepared to open some form of an insurance position to protect from a downside move in the share price. Remember, share prices are based on the expected financial performance of a company. If most investors expect the future for a company to be weaker than today then it will be difficult for the share price to rise.
Our next question on the Quality review is Q8 Dividend Track Record.
Quality Q8 – Dividend Track Record -Fundamental Analysis Guide
Here we simply award points based on the number of years of consecutive increases in dividends per share over the last five years. The maximum score is 4 and each consecutive increase starting with the dividend per share five years ago collects one point.
The track record for dividends is found on the row in the middle data table of your one page value line report called “Dividends declared per share”.
A track record of increasing dividends especially when the period covers a recession is a strong indication of company strength.
Note: Do check that the company has not simply increased borrowings (debt) to fund higher dividends.
Our penultimate question on the Quality review is Q9 Management.
Quality Q9 – Management – Fundamental Analysis Guide
This section incorporates an element of subjectivity. Warren Buffett said a good quality company is one which could perform well with or without its management! Bearing that in mind we will still make our own broad assessment of management using the following questions.
|Are profits increasing? Check Value Line report|
|Is management anticipating future trends? Research heartbeat, news etc|
|Have they handled past challenges? Again you need to read up on the company|
|Are there no pending significant lawsuits? See press releases etc|
For each Yes answer please enter “Y” into the box and collect one point.
Our final question on the Quality review is Q10 Return on Equity.
Quality Q10 – Return on Equity – Fundamental Analysis Guide
This is the final piece of information we consider under the quality evaluation of the company.
We wish to invest in stocks with return on equity (ROE) figures of 15% or higher. Companies which can consistently earn returns on equity over 15% can be deemed to have developed strong ‘moats’ around their business which makes it difficult for new entrants to impact on their business.
We take these figures from our quarterly value line report for each of the past five years. For each year which delivered 15% or higher we award 1 point.
The maximum score is 5 points.
Summary – Fundamental Analysis Guide
In conclusion my model in excel will then weight the scores for each of the ten questions above and multiply the various scores by the weighting. The sum of the weighted scores will fall into one of the categories below. The maximum score is 100.
Fig 1.3 Below is an example of one stock’s score on Quality (Q)
|Q10||Return on Equity ROE||4||**||8||10|
The final step to award the company a specific overall Quality grade is as follows:
|80-99 Ideal (A)||SMT Guide|
|60-79 High Range (B)||B|
|25-59 Low Range (C)|
|0-24 Red Flag (D)|
As you can see from the table above we award a Quality “A” rating to stocks which score 80 or higher points overall on the quality section. The stock above only earned 63 points and hence was awarded a “B” Quality grade.
Ideally we would buy only “A” rated quality companies. However, these companies can prove to very expensive. Remember fundamental data is public information mostly. Professional investors have identified the top quality companies and invest heavily in those. This drives up the share prices. Sometime it pushes them too high.
Fundamental Analysis Guide – How do we know if a company is value for money with its stock price?
This leads us to our next evaluation section which is Value for Money. In stock market terms that refers to share price. There is no point buying a top quality company if you are overpaying for it. This will likely lead to investment losses in the long run if you continually over pay for stocks no matter how good they are in terms of quality.
Hence you will often find yourself considering “B” rated quality stocks as these can more often have “A” rated Value for Money scores than the top quality stocks. It is difficult to find “A rated quality and “A” rated Value for Money stocks. Great patience is often required for these opportunities but they do arise so do not despair.
PART 2: VALUE FOR MONEY (V) -Fundamental Analysis Guide
When we identify good quality companies we then need to assess whether we can buy them at a reasonable price. Does the share price represent good Value for Money? No matter how much you might like an item when you go shopping if the price is deemed to be too high you are not likely to buy it. You might decide to wait for the ‘sales season’. The same can apply to timing of your stock purchases.
The Value for Money section of our company evaluation model requires us to consider a final set of ten questions to determine if the company share price is too high or not. In the Module on Technical Analysis you will learn how we use charts to help refine our entry and exit points. We use this tool after we have completed our fundamental review.
Our first question on the Value for Money evaluation considers the estimated annual returns.
V1 – Estimated Annual Return p.a. – Fundamental Analysis Guide
At the top left corner of your value line report you will find a box with the title “Projections”. This will indicate two figures. It will show the value line estimates for the highest price and lowest price for the stock over the next 3-5 years. It will also show the estimated total returns per annum in percentage terms. This % return figure includes both price appreciation and dividends.
Value Line models have determined these estimates using proprietary software which takes account of the current economic climate, the company’s operating fundamentals, management initiatives, rivals activities and many other factors which impact a company’s performance.
In my model we focus on the more conservative set of figures being the ‘Low’ end of the range of estimates.
We award point scores for three different % return ranges as follows:
- Estimated annual returns greater than or equal to 15% – award 5 points
- Estimated annual returns greater 10% to 15% – award 3 points
- Estimated annual returns less than 10% – award 1 point
Note: The market average return is approximately 10% per annum including dividends. The average pension fund aims at 5% to 6% per annum returns.
You will note that my model is designed to give stocks which are likely to deliver higher returns to the investor higher marks. This will help the investors to select stocks for their portfolios which should deliver them higher returns.
The second piece of information to consider under Value for Money is the consensus analyst price target for the stock.
V2 – Analyst Price Target -Fundamental Analysis Guide
Analysts publish their price targets for stocks. These are subject to review and update. This happens especially following an earnings report surprise and/or following a significant news release (remember the ‘heartbeat’ of the stock).
In general analyst share price targets represent the price they believe the share price should reach within the next six to twelve months. This is different from V1 which considered the average returns over the next three to five years. You would not expect the same average return over a five year period as you would over a single year. Rates of growth generally decline as companies grow larger.
Note: We treat analyst targets with caution. Remember the Value Line analysts are independent and unbiased. We cannot vouch for the analyst motives. However we can use the consensus or average analyst price targets as an indicator of ‘value’.
Analyst price targets can be found on many websites. You may find small differences between them but these should not materially affect the score. We use the following website for input to our Alpha Evaluation model – www.finviz.com . See below Fig 1.4
The scores we award for various upside percentage levels from the current share price to the consensus analyst one year price target are as follows:
- Estimated upside from current share price greater than or equal to 20% – award 5 points
- Estimated upside from current share price greater than or equal to 10% – award 3 points
- Estimated upside from current share price less than 10% – award 1 point
The third Value for Money question we consider is the price to earnings ratio.
3.3. V3 – Price Earnings Ratio (or P/E ratio)
The P/E ratio is one of the most widely used metrics for valuation of a company.
The price earnings ratio in simple terms is the share price divided by the company’s earnings per share. It is sometimes referred to as either the P/E ratio, the P/E multiple or the earnings multiple.
The value line report shows this figure in the top row of the report.
Calculation of the P/E Ratio
The share price used is the current share price. The earnings per share figure used can vary from one source to another. Hence, it is important when comparing different stocks to use a consistent approach to facilitate meaningful comparisons and conclusions.
All P/E ratios use 12 months of earnings per share (EPS).
The Value Line earnings per share figure uses the last two quarters or six months of actual reported adjusted earnings plus the next two quarters or six months of earnings projections.
Note: Newspapers often use the last twelve months of actual reported earnings. Sometimes you will hear analysts talk about the forward P/E ratio. This simply means they calculate the P/E ratio using the current price but divide it by the projected next 12 months of earnings.
Value Line calculates earnings by using the company reported earnings and then removing non-recurring or exceptional items such as for example one-off restructuring costs or gain / loss on the sale of assets (if that is not the core activity of the company). They do this so that the core or normal earnings for the company can be trended more meaningfully.
For example Microsoft reported a loss in July 2012. However, it would be silly to suddenly base your valuation on the earnings reported as that would incorporate an abnormal earnings quarter. The company wrote down the value of an acquisition on its books which it then had to report as a loss in its official earnings. However, as this was an exceptional or non-recurring charge we can remove it from our analysis to derive a more meaningful earnings figure for the quarter.
In fact most companies will also report adjusted earnings figures in any case. Accounting reports do allow for the separate identification of exceptional costs. This helps investors to see the core performance of the company.
Often Value Line will add a footnote if they have removed an unusual item from the reported earnings.
You will note on the Value Line report there are a several other P/E ratios indicated.
The Relative P/E ratio is simply the comparison of this stock’s P/E ratio with the median of all the other 1,700 stocks covered by Value Line. If the Relative P/E ratio is less than one it means this stock has a lower P/E ratio than the other 1,700.
The Trailing P/E ratio uses the earnings from the last 12 months actual reported earnings (adjusted for exceptional items). Recall this is what is often reported in the newspapers.
The Median P/E ratio is the average annual P/E ratio of a stock over the past 10 years. There are statistical adjustments made for extremely high or low P/E ratios over that time frame.
The Average Annual P/E ratio is derived by dividing the average share price for each year by the earnings for each year. This is the P/E ratio our model uses.
Our company evaluation model basically wants to award high value for money points to a company which is trading at a discount to its five year average P/E ratio. We want to award lower points if the P/E ratio is above the five year average.
To calculate the five year average P/E ratio we simply take the last five years of figures for the Average Annual P/E ratio from the one page Value Line report and divide by 5. Then we compare the current P/E ratio to this figure.
See the guidelines below which we use for the answer to V3:
- If current P/E ratio is equal to or lower than the 5 year average we award the full 5 points
- If current P/E ratio is above but less than twice the 5 year average we award 3 points
- If current P/E ratio is more than twice the 5 year average we award 1 point
This should make sense to all as you do not really want to pay more than double the usual multiple. We are not implying that stock prices will not rise when they have larger P/E ratios than normal but we are simply saying there is reason to exercise more caution in your company selection when this occurs.
In general, very high growth rate companies often trade at large P/E ratios because investors predict or expect much higher earnings in the future. The issue here is should the actual earnings come in below those high expectations you can see very sharp drops in share price.
Value line also provides a Relative Annual P/E ratio. This simply divides the stock’s average annual P/E ratio by the Average Annual P/E of all 1,700 stocks covered by Value Line. Hence one can compare the current Relative P/E ratio to the five year average Relative P/E ratio also.
Our fourth question to answer in determining Value for Money is the PEG ratio.
3.4. V4 – Price Earnings Growth Ratio (or PEG ratio)
Another popular metric for company valuation is the PEG ratio. This is derived by using the current PE ratio and dividing by the estimated five year earnings per share (EPS) growth rate.
|PEG =||Price Earnings Ratio (P/E)|
|EPS Growth Rate (5yr projection)|
Our Alpha model calculates this number using the Value Line data directly from your input section or you can simply use the ratio quoted per several financial websites such as www.finviz.com or www.morningstar.com
If you use Morningstar then you click on valuation and then look for PEG.
Fig 1.5 – The PEG ratio for MSFT is 1.49 using Finviz website
If you wish to calculate your own PEG then you can use the current PE ratio as per Value Line basis and divide by the Value Line earnings growth rate which is for 3-5 years though and is located in the Annual Rates of Change box on the left hand side of the one page report.
Note: As is the case when using any estimates the above relies on the accuracy of projections for the next five years.
The rule of thumb we apply to use the PEG ratio is simply as follows:
- If PEG is above zero but less than or equal to 1 we award the full 5 points
- If PEG is over 1.0 and less than or equal 1.5 we award 4 points
- If PEG is over 1.5 and less than or equal to 2.0 we award 3 points
- If PEG is over 2.0 and less than or equal 3.0 we award 1 point
- If PEG is above 3.0 or less than or equal to zero we award zero points
Note: Should the company earnings growth projection figure be zero or less than zero the model will award zero points. This can happen where a company has projected decreasing earnings thereby yielding a negative percentage for growth projection and hence the PEG figure would be calculated as a negative number. Obviously since this is not a good feature for a company we should award a low score.
As in all cases when a company only earns the minimum points score it should be considered as a warning or an important note of caution on the stock. Conversely, a PEG less than 1.0 is considered excellent value.
Unsurprisingly, we must consider the reliability of estimates for a company. Much of the Value for Money evaluation rests on various projections of the company’s financial performance. Hence, our next question relates to the level of earnings predictability.
3.5. V5 – Earnings Predictability
The expected future price of a stock is largely driven by future expectations of the company’s earnings. As such it is very important that estimates of future prices are backed up with highly predictable earnings. Otherwise the validity of the projected earnings estimates and hence price targets are seriously compromised.
The Value Line report indicates the Earnings Predictability score at the bottom right hand corner on the quarterly one page report. The higher the score as measured in percentiles the higher the predictability.
In simple terms we can deem the consensus earnings projections as more reliable.
Our scoring system awards points as follows:
|Earnings Predictability between 90 and 100 is Ideal so we award 5 points|
|Earnings Predictability between 75 and 89 – we award 4 points|
|Earnings Predictability Rank between 50 and 74 – we award 2 points|
|Earnings Predictability less than 50 – we award 1 only point|
Our next question on Value for Money is to consider the reward to risk ratio.
3.6. V6 – Risk to Reward ratio
The risk to reward ratio is simply a ratio of the potential upside to the potential downside.
To calculate the amount of upside and potential downside in a stock price we can use the trend from the past five years and then apply this to our Value Line projections for the next five years.
Let’s take the last five years and determine a five year basic ‘average’ P/E ratio using both the lowest and highest share prices each year and the actual year’s earnings or EPS (as per Value the Line one page report).
Firstly, key onto the Excel Alpha model the figures for the past five years for earnings per share and high and low share prices directly from your one page value line report.
We simply calculate the average of the 5 highest and lowest prices. We then divide each by the average EPS (earnings per share) and this gives us a basic average 5 year P/E ratio using the highest prices and one using the lowest prices.
To estimate the potential highest share price for the stock over the next 3-5 years we multiply our average P/E ratio using the highest share price by the projected EPS figure per Value Line for the next 3-5 years (V6c).
This is actually calculated for you on the model automatically once the raw data has been input.
Note: Keep an eye on the Earnings Predictability % score at the bottom right hand corner of your one page Value Line report. The lower this figure the less confidence we can have with respect to the projected earnings. Obviously this will impact the confidence level we have in the projected price targets for the stock.
This figure represents our estimate of the highest stock price expected during the next 3-5 years. If we deduct from that the current share price then we have the estimated upside.
Using the average 5 year P/E ratio calculated above using the lowest share prices we can then multiply this by last year’s actual EPS figure. We do this based on the assumption that the company has no growth going forward. This gives us a basic estimate for the low price. We then deduct the current price from this low price ‘estimate’ to determine the dollar downside risk.
Note: You will find stocks below the low price estimates occasionally!
The reward to risk ratio is then calculated using the Upside divided by the Downside figures.
We then apply the following rule to award points:
- If the upside/downside ratio is greater than or equal to 4.0 we award the full five points
- If the ratio is between 3.0 and 4.0 we award four points
- If the ratio is between 2.0 and 3.0 we award three points
- If the ratio is less than 2 we award only one point
Note: Some companies may have reported losses or negative earnings per share in one or more of the past five years. This may distort the upside and downside prices but the risk reward ratio is all we need to assess in this section.
You should be very cautious about investing in companies which have been losing money. You need to be certain the future is brighter for the company’s earnings prospects. Ensure you employ one of the capital protection strategies as outlined later in this manual.
Again we are trying to ensure more attractive companies are awarded more points than those with less attractive prospects. This is done with the objective to help us select companies in which to invest in our portfolio.
The next piece of information we wish to use is actually a figure from our charts system. A secondary aim of this question is to ‘force’ the investor to actually look at the charts and not to take ‘short cuts’ by overlooking the charts. Whilst we pay great attention to the fundamentals we strongly urge the investor to consider the charts for a stock before actually making an investment.
3.7. V7 – Stochastics
A detailed explanation of Stochastics is provided in the Technical Analysis Module 4. In very simple terms one can think of this measure as an indication of the level of overbought or oversold for a particular stock.
In the model we use we will look at the short term stochastic (14 day) on our daily charts.
Fig 1.6 Charts – Stochastics (Short Term) Oversold
Fig 1.7 Charts – Stochastics (Short Term) Overbought
The points which we award are based on the following guideline:
- Stochastic greater than or equal to 80 – warning, award only 1 point
- Stochastic between 20 and 80 –award 3 points
- Stochastic less than 20 –award 5 points
Note: The stochastic score changes every day. It will not move between the above zones everyday but you should be aware it changes regularly and you need to update your evaluation sheet or excel file before you decide to invest.
V8 – Dividend Payout Ratios – Fundamental Analysis Guide
This section of our Value for Money research considers the level of dividends paid to shareholders.
The reasons for considering the payout ratio are twofold. Firstly, if the ratio is too high it reduces the amount of capital which can be used by the company to increase the earnings of the company. This will in turn impact the share price growth prospects.
Secondly, many investors are very sensitive to the changes in dividends. Many will actually sell stocks which have either decided not to increase dividends after a period of consecutive annual increases or which suddenly decrease a dividend.
To give us some indication of the likelihood of this occurring we look at the payout ratio. If a company is paying out a very high percentage of its earnings or cash flow then should the business encounter a difficult trading period it would be a higher risk of disappointment on the dividends front. This in turn could lead to falling share prices as long term holders might move away from a stock.
The first payout ratio we use is based on the earnings per share. We express dividends per share as a % of earnings per share. The dividend amount is found either in the dividends by quarter box on the bottom left corner or under the row “Dividends declared per share” of the value line report.
We apply the following points depending on the payout %:
- If the EPS % payout is above 60% we award only 1 point.
- If the EPS % payout is between 30% and 60% we award 5 points (this shows both respect for shareholders and an interest in driving future growth)
- If the EPS % payout is below 30% we award 3 points
Companies which have long track records of paying dividends and increasing dividends annually tend to perform very well and provide stable returns on investment for investors. Hence, we reward reasonable payouts more than small payout ratios.
Of course if the payout ratio is too high it reduces the growth potential for the company and hence we award a low score. The other risk as mentioned above with high payout ratios is the risk of cuts in dividends which can send investors heading for the exits.
Our second payout ratio is calculated using the cash flow of the company. Dividends are cash payments to shareholders. While it is possible to manipulate earnings figures it is more difficult to do so with cash!
We use Free Cash Flow for this ratio. Free Cash Flow (FCF) is the earnings plus depreciation and amortisation less capital expenditure, preferred dividend payments and debt obligations. We can find the FCF figure for the trailing 12 months (TTM – Trailing Twelve Months) on the www.morningstar.com website.
|How find the FCF data?|
|1.||Go to www.morningstar.com|
|2.||Enter Stock Ticker ,e.g. CSCO|
|3.||Go to Financials Tab|
|4.||Click on Cash Flow|
|5.||Scroll to bottom, use TTM column figure for FCF|
Fig 1.8 Morningstar Cash flow screenshot – TTM = $29,145k for Microsoft
To calculate Free Cash Flow per share simply divide the FCF figure (in millions) by the number of shares (in millions). You will see the number of shares outstanding on your one page Value Line report under Capital Structure.
|Free Cash Flow ($ m) divide by|
|No. Of shares in millions|
The same rules as per EPS payout apply.
- If the FCF % payout is above 60% we award only 1 point.
- If the FCF % payout is between 30% and 60% we award 5 points (this shows both respect for shareholders and an interest in driving future growth)
- If the FCF % payout is below 30% we award 3 points
Our penultimate question on Value for Money is to consider the performance of sales growth rates versus earnings growth rates.
Value for money: V9 – Sales v Earnings growth rates – Fundamental Analysis Guide
This piece of information looks at both the prior five year period and the projection for the next three to five year period. The Alpha model calculates this score automatically.
Ideally, we would see earnings percentage growth rates exceeding sales growth rates in both periods. This would confirm the company is run very efficiently and such growth should maintain a healthy price earnings multiple.
The % growth rates data can be located on your one page Value Line report on the left hand side under the heading “Annual Rates of Change”.
The score is awarded as follows:
- If earnings growth outperformed in both period we award the maximum five points
- If earnings outperform in one period we award three points
- If earnings underperform sales growth rates in both periods we award only one point
Value for money: V10 – Total Stock Return over Last 5 Years
Our final question on Value for Money is to consider the total stock return over the past five years.
This figure is available from your one page Value Line report at the top right hand corner under the heading “% Total Return”. This % figure includes share price movement plus dividends paid.
We would like to see the stock has delivered a positive return over the past five years. As such, we award the full marks only if a positive return was delivered.
If the stock delivered a negative return over the past five years we award the stock only one point. As mentioned earlier scores of one point should give rise to a note of caution to the potential investor.
Fundamental Analysis Guide
In conclusion our model in excel will then weight the scores for each of the ten questions above and multiply the various scores by the weighting. The sum of the weighted scores will fall into one of the categories below. The maximum score is 100.
Below is an example of one stock’s score on Value for Money (V):
|V1||Estimated Annual Return||5||**||10||10|
|V8||Dividend Payout %||6||*||6||10|
|V9||Sales v Earnings||3||*||3||5|
|V10||Five Year Return||1||**||2||10|
The final step to award the company a specific overall Value for Money grade is as follows:
|80-99 Ideal (A)||SMT Guide|
|60-79 High Range (B)|
|25-59 Low Range (C)||A|
|0-24 Red Flag (D)|
The sample stock has achieved a “B” rating for Quality and an “A” rating for Value for Money.
In simple terms we would prefer top marks for both Quality and Value. However, those opportunities are rare. However, a B & A rating is still very respectable and is worthy of serious consideration for investment.
As your grades drop to say B & B then we would become much less enthusiastic about the prospects for such an investment. We would also be inclined to reduce the position size and allocation within our portfolio if we really did wish to invest in this grade of stock. Strictly such stocks should be linked to a specific ‘insurance’ strategy to limit downside. See module on Portfolio Allocation and Capital Protection.
Now it is time to prepare a live example yourself!
Step 1. Select a company to review
Step 2. Go to Valueline.com and print off the latest Value Line One page report. See Fig 1.6 below for an example of a quarterly value line report on Microsoft (MSFT) as at November 16th 2012.
Step 3. Complete the Quality and Value Alpha Evaluation Excel based spreadsheet model. Please download the file from the Traders Lounge at www.waverleyfinancial.org
I’m sure hope you will find this systematic approach to evaluating various stocks under consideration for an investment in your portfolio a most useful tool. At the very least it will force you to consider many important elements which affect the share price performance of a stock. You will become much more informed by working through the model and this will keep you from simply making investments based on the newspaper tips!
Note: For investors who wish to see more detail on financial ratios there are a plethora of websites offering this information.
One website to visit is www.dailyfinance.com . This website contains very convenient comparisons of your stock to the industry ratios. Simply enter your stock ticker and click on Financial Ratios.
Key financial ratios can also be found at www.morningstar.com under “Key Ratios”.
Fig 1.9 Sample Value Line Report on Microsoft
Quarterly Model Score Review – Fundamental Analysis Guide
It is important to remember the one page Value Line reports are issued every three months. We recommend each investor to complete our Evaluation model as soon as the Value Line report is published. This should help you ensure your rationale for investing in a particular stock remains valid.
Three months may not seem like a long time but major events can occur which impact the future earnings of a company. For example, a lawsuit can result in the loss of patent protection, fines and unexpected royalty payments, a new product launch from a rival can hurt sales expectations etc.
Finally I encourage you to READ, READ and READ. Keep informed about your stocks and review your charts. You do not need to become full time investors but you owe it to yourself to make decisions based on the awareness of the latest reliable information which is available to you if you choose to look for it!
So now you have all the tools you need to evaluate any USA stock to assess if its a quality company worth investing in and if the price the stock is at represents true value.
Summary of Fundamental Analysis
When talking about stocks, fundamental analysis is a technique that attempts to determine a security’s value by focusing on underlying factors that affect a company’s actual business and its future prospects. On a broader scope, you can perform fundamental analysis on industries or the economy as a whole. The term simply refers to the analysis of the economic well-being of a financial entity as opposed to only its price movements.
Fundamental analysis serves to answer questions, such as:
- Is the company’s revenue growing?
- Is it actually making a profit?
- Is it in a strong-enough position to beat out its competitors in the future?
- Is it able to repay its debts?
- Is management trying to “cook the books“?
Of course, these are very involved questions, and there are literally hundreds of others you might have about a company. It all really boils down to one question: Is the company’s stock a good investment? Think of fundamental analysis as a toolbox to help you answer this question.
Note: The term fundamental analysis is used most often in the context of stocks, but you can perform fundamental analysis on any security, from a bond to a derivative. As long as you look at the economic fundamentals, you are doing fundamental analysis. For the purpose of this tutorial, fundamental analysis always is referred to in the context of stocks.
Fundamentals: Quantitative and Qualitative You could define fundamental analysis as “researching the fundamentals”, but that doesn’t tell you a whole lot unless you know what fundamentals are. As we mentioned in the introduction, the big problem with defining fundamentals is that it can include anything related to the economic well-being of a company. Obvious items include things like revenue and profit, but fundamentals also include everything from a company’s market share to the quality of its management.
The various fundamental factors can be grouped into two categories: quantitative and qualitative. The financial meaning of these terms isn’t all that different from their regular definitions. Here is how the MSN Encarta dictionary defines the terms:
- Quantitative – capable of being measured or expressed in numerical terms.
- Qualitative – related to or based on the quality or character of something, often as opposed to its size or quantity.
In our context, quantitative fundamentals are numeric, measurable characteristics about a business. It’s easy to see how the biggest source of quantitative data is the financial statements. You can measure revenue, profit, assets and more with great precision.
Turning to qualitative fundamentals, these are the less tangible factors surrounding a business – things such as the quality of a company’s board members and key executives, its brand-name recognition, patents or proprietary technology.
Quantitative Meets Qualitative Neither qualitative nor quantitative analysis is inherently better than the other. Instead, many analysts consider qualitative factors in conjunction with the hard, quantitative factors. Take the Coca-Cola Company, for example. When examining its stock, an analyst might look at the stock’s annual dividend payout, earnings per share, P/E ratio and many other quantitative factors. However, no analysis of Coca-Cola would be complete without taking into account its brand recognition. Anybody can start a company that sells sugar and water, but few companies on earth are recognized by billions of people. It’s tough to put your finger on exactly what the Coke brand is worth, but you can be sure that it’s an essential ingredient contributing to the company’s ongoing success.
The Concept of Intrinsic Value
Before we get any further, we have to address the subject of intrinsic value. One of the primary assumptions of fundamental analysis is that the price on the stock market does not fully reflect a stock’s “real” value. After all, why would you be doing price analysis if the stock market were always correct? In financial jargon, this true value is known as the intrinsic value.
For example, let’s say that a company’s stock was trading at $20. After doing extensive homework on the company, you determine that it really is worth $25. In other words, you determine the intrinsic value of the firm to be $25. This is clearly relevant because an investor wants to buy stocks that are trading at prices significantly below their estimated intrinsic value.
This leads us to one of the second major assumptions of fundamental analysis: in the long run, the stock market will reflect the fundamentals. There is no point in buying a stock based on intrinsic value if the price never reflected that value. Nobody knows how long “the long run” really is. It could be days or years.
This is what fundamental analysis is all about. By focusing on a particular business, an investor can estimate the intrinsic value of a firm and thus find opportunities where he or she can buy at a discount. If all goes well, the investment will pay off over time as the market catches up to the fundamentals.
The big unknowns are:
1)You don’t know if your estimate of intrinsic value is correct; and
2)You don’t know how long it will take for the intrinsic value to be reflected in the marketplace.
Technical analysis is the other major form of security analysis. We’re not going to get into too much detail on the subject. (More information is available in our Introduction to Technical Analysis tutorial.)
Put simply, technical analysts base their investments (or, more precisely, their trades) solely on the price and volume movements of securities. Using charts and a number of other tools, they trade on momentum, not caring about the fundamentals. While it is possible to use both techniques in combination, one of the basic tenets of technical analysis is that the market discounts everything. Accordingly, all news about a company already is priced into a stock, and therefore a stock’s price movements give more insight than the underlying fundamental factors of the business itself.
Followers of the efficient market hypothesis, however, are usually in disagreement with both fundamental and technical analysts. The efficient market hypothesis contends that it is essentially impossible to produce market-beating returns in the long run, through either fundamental or technical analysis. The rationale for this argument is that, since the market efficiently prices all stocks on an ongoing basis, any opportunities for excess returns derived from fundamental (or technical) analysis would be almost immediately whittled away by the market’s many participants, making it impossible for anyone to meaningfully outperform the market over the long term.
sUMMARY OF fUNDAMENTAL aNALYSIS qUALITATIVE faCTORS
Fundamental analysis seeks to determine the intrinsic value of a company’s stock. But since qualitative factors, by definition, represent aspects of a company’s business that are difficult or impossible to quantify, incorporating that kind of information into a pricing evaluation can be quite difficult. On the flip side, as we’ve demonstrated, you can’t ignore the less tangible characteristics of a company.
Even before an investor looks at a company’s financial statements or does any research, one of the most important questions that should be asked is: What exactly does the company do? This is referred to as a company’s business model – it’s how a company makes money. You can get a good overview of a company’s business model by checking out its website or reading the first part of its 10-K filing (Note: We’ll get into more detail about the 10-K in the financial statements chapter. For now, just bear with us).
Sometimes business models are easy to understand. Take McDonalds, for instance, which sells hamburgers, fries, soft drinks, salads and whatever other new special they are promoting at the time. It’s a simple model, easy enough for anybody to understand.
Other times, you’d be surprised how complicated it can get. Boston Chicken Inc. is a prime example of this. Back in the early ’90s its stock was the darling of Wall Street. At one point the company’s CEO bragged that they were the “first new fast-food restaurant to reach $1 billion in sales since 1969”. The problem is, they didn’t make money by selling chicken. Rather, they made their money from royalty fees and high-interest loans to franchisees. Boston Chicken was really nothing more than a big franchisor. On top of this, management was aggressive with how it recognized its revenue. As soon as it was revealed that all the franchisees were losing money, the house of cards collapsed and the company went bankrupt.
At the very least, you should understand the business model of any company you invest in. The “Oracle of Omaha“, Warren Buffett, rarely invests in tech stocks because most of the time he doesn’t understand them. This is not to say the technology sector is bad, but it’s not Buffett’s area of expertise; he doesn’t feel comfortable investing in this area. Similarly, unless you understand a company’s business model, you don’t know what the drivers are for future growth, and you leave yourself vulnerable to being blindsided like shareholders of Boston Chicken were.
Competitive Advantage Another business consideration for investors is competitive advantage. A company’s long-term success is driven largely 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 competitive advantage, its shareholders can be well rewarded for decades.
|Harvard Business School professor Michael Porter, distinguishes between strategic positioning and operational effectiveness. Operational effectiveness means a company is better than rivals at similar activities while competitive advantage means a company is performing better than rivals by doing different activities or performing similar activities in different ways. Investors should know that few companies are able to compete successfully for long if they are doing the same things as their competitors. Professor Porter argues that, in general, sustainable competitive advantage gained by:A unique competitive positionClear tradeoffs and choices vis-à-vis competitorsActivities tailored to the company\’s strategyA high degree of fit across activities (it is the activity system, not the parts, that ensure sustainability)A high degree of operational effectiveness|
Management Just as an army needs a general to lead it to victory, a company relies upon management to steer it towards financial success. Some believe that management is the most important aspect for investing in a company. It makes sense – even the best business model is doomed if the leaders of the company fail to properly execute the plan.
So how does an average investor go about evaluating the management of a company?
This is one of the areas in which individuals are truly at a disadvantage compared to professional investors. You can’t set up a meeting with management if you want to invest a few thousand dollars. On the other hand, if you are a fund manager interested in investing millions of dollars, there is a good chance you can schedule a face-to-face meeting with the upper brass of the firm.
Every public company has a corporate information section on its website. Usually there will be a quick biography on each executive with their employment history, educational background and any applicable achievements. Don’t expect to find anything useful here. Let’s be honest: We’re looking for dirt, and no company is going to put negative information on its corporate website.
Instead, here are a few ways for you to get a feel for management:
1. Conference Calls
The Chief Executive Officer (CEO) and Chief Financial Officer (CFO) host quarterly conference calls. (Sometimes you’ll get other executives as well.) The first portion of the call is management basically reading off the financial results. What is really interesting is the question-and-answer portion of the call. This is when the line is open for analysts to call in and ask management direct questions. Answers here can be revealing about the company, but more importantly, listen for candor. Do they avoid questions, like politicians, or do they provide forthright answers?
2. Management Discussion and Analysis (MD&A) The Management Discussion and Analysis is found at the beginning of the annual report (discussed in more detail later in this tutorial). In theory, the MD&A is supposed to be frank commentary on the management’s outlook. Sometimes the content is worthwhile, other times it’s boilerplate. One tip is to compare what management said in past years with what they are saying now. Is it the same material rehashed? Have strategies actually been implemented? If possible, sit down and read the last five years of MD&As; it can be illuminating.
3. Ownership and Insider Sales Just about any large company will compensate executives with a combination of cash, restricted stock and options. While there are problems with stock options (See Putting Management Under the Microscope), it is a positive sign that members of management are also shareholders. The ideal situation is when the founder of the company is still in charge. Examples include Bill Gates (in the ’80s and ’90s), Michael Dell and Warren Buffett. When you know that a majority of management’s wealth is in the stock, you can have confidence that they will do the right thing. As well, it’s worth checking out if management has been selling its stock. This has to be filed with the Securities and Exchange Commission (SEC), so it’s publicly available information. Talk is cheap – think twice if you see management unloading all of its shares while saying something else in the media.
4. Past Performance Another good way to get a feel for management capability is to check and see how executives have done at other companies in the past. You can normally find biographies of top executives on company web sites. Identify the companies they worked at in the past and do a search on those companies and their performance.
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 and its bylaws, along with corporate laws and regulations. The purpose of corporate governance policies is to ensure that proper checks and balances are in place, making it more difficult for anyone to conduct unethical and illegal activities.
Good corporate governance is a situation in which a company complies with all of its governance policies and applicable government regulations (such as the Sarbanes-Oxley Act of 2002) in order to look out for the interests of the company’s investors and other stakeholders.
Although, there are companies and organizations (such as Standard & Poor’s) that attempt to quantitatively assess companies on how well their corporate governance policies serve stakeholders, most of these reports are quite expensive for the average investor to purchase.
Fortunately, corporate governance policies typically cover a few general areas: structure of the board of directors, stakeholder rights and financial and information transparency. With a little research and the right questions in mind, investors can get a good idea about a company’s corporate governance.
Financial and Information Transparency This aspect of governance relates to the quality and timeliness of a company’s financial disclosures and operational happenings. Sufficient transparency implies that a company’s financial releases are written in a manner that stakeholders can follow what management is doing and therefore have a clear understanding of the company’s current financial situation.
Stakeholder Rights This aspect of corporate governance examines the extent that a company’s policies are benefiting stakeholder interests, notably shareholder interests. Ultimately, as owners of the company, shareholders should have some access to the board of directors if they have concerns or want something addressed. Therefore companies with good governance give shareholders a certain amount of ownership voting rights to call meetings to discuss pressing issues with the board.
Another relevant area for good governance, in terms of ownership rights, is whether or not a company possesses large amounts of takeover defenses (such as the Macaroni Defense or the Poison Pill) or other measures that make it difficult for changes in management, directors and ownership to occur. (To read more on takeover strategies, see The Wacky World of M&As.)
Structure of the Board of Directors The board of directors is composed of representatives from the company and representatives from outside of the company. The combination of inside and outside directors attempts to provide an independent assessment of management’s performance, making sure that the interests of shareholders are represented.
The key word when looking at the board of directors is independence. The board of directors is responsible for protecting shareholder interests and ensuring that the upper management of the company is doing the same. The board possesses the right to hire and fire members of the board on behalf of the shareholders. A board filled with insiders will often not serve as objective critics of management and will defend their actions as good and beneficial, regardless of the circumstances.
Information on the board of directors of a publicly traded company (such as biographies of individual board members and compensation-related info) can be found in the DEF 14A proxy statement.
Fundamental Analysis: Qualitative Factors – The Industry
Each industry has differences in terms of its customer base, market share among firms, industry-wide growth, competition, regulation and business cycles. Learning about how the industry works will give an investor a deeper understanding of a company’s financial health.
Customers Some companies serve only a handful of customers, while others serve millions. In general, it’s a red flag (a negative) if a business relies on a small number of customers for a large portion of its sales because the loss of each customer could dramatically affect revenues. For example, think of a military supplier who has 100% of its sales with the U.S.government. One change in government policy could potentially wipe out all of its sales. For this reason, companies will always disclose in their 10-K if any one customer accounts for a majority of revenues.
Market Share Understanding a company’s present market share can tell volumes about the company’s business. The fact that a company possesses an 85% market share tells you that it is the largest player in its market by far. Furthermore, this could also suggest that the company possesses some sort of “economic moat,” in other words, a competitive barrier serving to protect its current and future earnings, along with its market share. Market share is important because of economies of scale. When the firm is bigger than the rest of its rivals, it is in a better position to absorb the high fixed costs of a capital-intensive industry.
Industry Growth One way of examining a company’s growth potential is to first examine whether the amount of customers in the overall market will grow. This is crucial because without new customers, a company has to steal market share in order to grow.
In some markets, there is zero or negative growth, a factor demanding careful consideration. For example, a manufacturing company dedicated solely to creating audio compact cassettes might have been very successful in the ’70s, ’80s and early ’90s. However, that same company would probably have a rough time now due to the advent of newer technologies, such as CDs and MP3s. The current market for audio compact cassettes is only a fraction of what it was during the peak of its popularity.
Competition Simply looking at the number of competitors goes a long way in understanding the competitive landscape for a company. Industries that have limited barriers to entry and a large number of competing firms create a difficult operating environment for firms.
One of the biggest risks within a highly competitive industry is pricing power. This refers to the ability of a supplier to increase prices and pass those costs on to customers. Companies operating in industries with few alternatives have the ability to pass on costs to their customers. A great example of this is Wal-Mart. They are so dominant in the retailing business, that Wal-Mart practically sets the price for any of the suppliers wanting to do business with them. If you want to sell to Wal-Mart, you have little, if any, pricing power.
Regulation Certain industries are heavily regulated due to the importance or severity of the industry’s products and/or services. As important as some of these regulations are to the public, they can drastically affect the attractiveness of a company for investment purposes.
In industries where one or two companies represent the entire industry for a region (such as utility companies), governments usually specify how much profit each company can make. In these instances, while there is the potential for sizable profits, they are limited due to regulation.
In other industries, regulation can play a less direct role in affecting industry pricing. For example, the drug industry is one of most regulated industries. And for good reason – no one wants an ineffective drug that causes deaths to reach the market. As a result, the U.S. Food and Drug Administration (FDA) requires that new drugs must pass a series of clinical trials before they can be sold and distributed to the general public. However, the consequence of all this testing is that it usually takes several years and millions of dollars before a drug is approved. Keep in mind that all these costs are above and beyond the millions that the drug company has spent on research and development.
All in all, investors should always be on the lookout for regulations that could potentially have a material impact upon a business’ bottom line. Investors should keep these regulatory costs in mind as they assess the potential risks and rewards of investing.
Fundamental Analysis: Introduction to Financial Statements
The massive amount of numbers in a company’s financial statements can be bewildering and intimidating to many investors. On the other hand, if you know how to analyze them, the financial statements are a gold mine of information.
Financial statements are the medium by which a company discloses information concerning its financial performance. Followers of fundamental analysis use the quantitative information gleaned from financial statements to make investment decisions. Before we jump into the specifics of the three most important financial statements – income statements, balance sheets and cash flow statements – we will briefly introduce each financial statement’s specific function, along with where they can be found.
The Major Statements The Balance Sheet The balance sheet represents a record of a company’s assets, liabilities and equity at a particular point in time. The balance sheet is named by the fact that a business’s financial structure balances in the following manner:
|Assets = Liabilities + Shareholders\’ Equity|
Assets represent the resources that the business owns or controls at a given point in time. This includes items such as cash, inventory, machinery and buildings. The other side of the equation represents the total value of the financing the company has used to acquire those assets. Financing comes as a result of liabilities or equity. Liabilities represent debt (which of course must be paid back), while equity represents the total value of money that the owners have contributed to the business – including retained earnings, which is the profit made in previous years.
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 information about revenues, expenses and profit that was generated as a result of 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:
- Operating Cash Flow (OCF): Cash generated from day-to-day business operations
- 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
The cash flow statement is important because it’s very difficult 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.
10-K and 10-Q Now that you have an understanding of what the three financial statements represent, let’s discuss where an investor can go about finding them. In the United States, the Securities And Exchange Commission (SEC) requires all companies that are publicly traded on a major exchange to submit periodic filings detailing their financial activities, including the financial statements mentioned above.
Some other pieces of information that are also required are an auditor’s report, management discussion and analysis(MD&A) and a relatively detailed description of the company’s operations and prospects for the upcoming year.
All of this information can be found in the business’ annual 10-K and quarterly 10-Q filings, which are released by the company’s management and can be found on the internet or in physical form. (For more information, see Where can I find a company’s annual report and its SEC filings?)
The 10-K is an annual filing that discloses a business’s performance over the course of the fiscal year. In addition to finding a business’s financial statements for the most recent year, investors also have access to the business’s historical financial measures, along with information detailing the operations of the business. This includes a lot of information, such as the number of employees, biographies of upper management, risks, future plans for growth, etc.
Businesses also release an annual report, which some people also refer to as the 10-K. The annual report is essentially the 10-K released in a fancier marketing format. It will include much of the same information, but not all, that you can find in the 10-K. The 10-K really is boring – it’s just pages and pages of numbers, text and legalese. But just because it’s boring doesn’t mean it isn’t useful. There is a lot of good information in a 10-K, and it’s required reading for any serious investor.
You can think of the 10-Q filing as a smaller version of a 10-K. It reports the company’s performance after each fiscal quarter. Each year three 10-Q filings are released – one for each of the first three quarters. (Note: There is no 10-Q for the fourth quarter, because the 10-K filing is released during that time). Unlike the 10-K filing, 10-Q filings are not required to be audited. Here’s a tip if you have trouble remembering which is which: think “Q” for quarter.
Fundamental Analysis: Other Important Sections Found in Financial Filings
The financial statements are not the only parts found in a business’s annual and quarterly SEC filings. Here are some other noteworthy sections:
Management Discussion and Analysis (MD&A)
As a preface to the financial statements, a company’s management will typically spend a few pages talking about the recent year (or quarter) and provide background on the company. This is referred to as the management discussion and analysis (MD&A). In addition to providing investors a clearer picture of what the company does, the MD&A also points out some key areas in which the company has performed well.
Don’t expect the letter from management to delve into all the juicy details affecting the company’s performance. The management’s analysis is at their discretion, so understand they probably aren’t going to be disclosing any negatives.
Here are some things to look out for:
- How candid and accurate are management’s comments?
- Does management discuss significant financial trends over the past couple years? (As we’ve already mentioned, it can be interesting to compare the MD&As over the last few years to see how the message has changed and whether management actually followed through with its plan.)
- How clear are management’s comments? If executives try to confuse you with big words and jargon, perhaps they have something to hide.
- Do they mention potential risks or uncertainties moving forward?
Disclosure is the name of the game. If a company gives a decent amount of information in the MD&A, it’s likely that management is being upfront and honest. It should raise a red flag if the MD&A ignores serious problems that the company has been facing.
The Auditor’s Report
The auditors’ job is to express an opinion on whether the financial statements are reasonably accurate and provide adequate disclosure. This is the purpose behind the auditor’s report, which is sometimes called the “report of independent accountants”.
By law, every public company that trades stocks or bonds on an exchange must have its annual reports audited by a certified public accountants firm. An auditor’s report is meant to scrutinize the company and identify anything that might undermine the integrity of the financial statements.
The typical auditor’s report is almost always broken into three paragraphs and written in the following fashion:
|Independent Auditor’s Report Paragraph 1 Recounts the responsibilities of the auditor and directors in general and lists the areas of the financial statements that were audited. Paragraph 2 Lists how the generally accepted accounting principles (GAAP) were applied, and what areas of the company were assessed. Paragraph 3 Provides the auditor’s opinion on the financial statements of the company being audited. This is simply an opinion, not a guarantee of accuracy.|
While the auditor’s report won’t uncover any financial bombshells, audits give credibility to the figures reported by management. You’ll only see un-audited financials for unlisted firms (those that trade OTCBB or on the Pink Sheets). While quarterly statements aren’t audited, you should be very wary of any annual financials that haven’t been given the accountants’ stamp of approval.
The Notes to the Financial Statements
Just as the MD&A serves an introduction to the financial statements, the notes to the financial statements (sometimes called footnotes) tie up any loose ends and complete the overall picture. If the income statement, balance sheet and statement of cash flows are the heart of the financial statements, then the footnotes are the arteries that keep everything connected. Therefore, if you aren’t reading the footnotes, you’re missing out on a lot of information.
The footnotes list important information that could not be included in the actual ledgers. For example, they list relevant things like outstanding leases, the maturity dates of outstanding debt and details on compensation plans, such as stock options, etc.
Generally speaking there are two types of footnotes:
Accounting Methods – This type of footnote identifies and explains the major accounting policies of the business that the company feels that you should be aware of. This is especially important if a company has changed accounting policies. It may be that a firm is practicing “cookie jar accounting” and is changing policies only to take advantage of current conditions in order to hide poor performance.
Disclosure – The second type of footnote provides additional disclosure that simply could not be put in the financial statements. The financial statements in an annual report are supposed to be clean and easy to follow. To maintain this cleanliness, other calculations are left for the footnotes. For example, details of long-term debt – such as maturity dates and the interest rates at which debt was issued – can give you a better idea of how borrowing costs are laid out. Other areas of disclosure include everything from pension plan liabilities for existing employees to details about ominous legal proceedings involving the company.
The majority of investors and analysts read the balance sheet, income statement and cash flow statement but, for whatever reason, the footnotes are often ignored. What sets informed investors apart is digging deeper and looking for information that others typically wouldn’t. No matter how boring it might be, read the fine print – it will make you a better investor.
4. MULTIPLE CHOICE TEST QUESTIONS ON FUNDAMENTAL ANALYSIS
This section consists of a series of multiple choice questions designed to confirm you understand the key points of this blog.
Only one answer is correct. Choose which one you believe is correct. The correct answers are identified at the end.
Don’t cheat yourself. If you get some wrong then reread the material to improve your understanding or ask for clarification.
Q1. Should one plan for Financial Freedom if you wish to be financially free?
Q2. What is the name of our Company Evaluation model?
- The Alpha Model
- The Barney Model
- None of the above
Q3. The Alpha model aims to identify top quality companies at good value for money prices. The top score for either Quality or Value for Money is
Q4. Which of the following Value Line ranks for Timeliness indicate the group of stocks which tends to outperform the price rises of other stocks over the long term?
- Rank 5
- Rank 3
- Rank 1
Q5. To earn an “A” grade on the Alpha model you require a score of?
- 80 or higher
Q6. What is the frequency of Value Line’s one page stock reports?
Q7. Which of the following is true?
- A stock with a Beta score less than 1.00 will tend to move at a slower rate than the overall market
- A stock with a Beta score less than 1.00 will tend to move at a faster rate than the overall market
Q8. Conservative investors prefer Beat scores?
- Well above 1.00
- Under or near 1.00
Q9. To what does the term ‘Heartbeat’ of the company refer?
- Covered Call Strategy
- The news flow surrounding the company.
Q10. How many stocks can hold the coveted Timeliness Rank 1 at any one time?
MODULE 3 – Correct Answers
A: If you score 9 or 10
B: If you score 7 or 8
C: If you score 6 or lower.
Please read through the text section relating to the questions you answered incorrectly.