Interpreting Financial Statements & Balance Sheets (Fundamental Analysis)

Financial statements and balance sheets are complex.  The best way to learn is to take a course in accounting or read a book about accounting or financial statements.  A successful active investor will need to be able to read and interpret corporate financial data.  Different investors will focus on different factors.  However, even the novice investor can look for certain key pieces of information and learn a few key ratios that can help them with their investing decisions.  Here are just a few things you might look at.  There are many more for the more seasoned investor.


  • Earnings:  If a company isn’t making money, chances are you won't either.  Earnings are probably the single most important figure to look at.  Earnings are what a company makes after it takes out its expenses.  Earnings are the most important ingredient in calculating the value and performance of a company, especially how it stacks up against its competitors, industry and the market.

 

Things To Look For:

  • Look for companies with a consistent growth in earnings. 
  • Look for companies whose annual earnings in the last three years have significantly outpaced the market. 
  • A company whose earnings are growing faster than its competitors should also have a stock whose price should grow faster too.
  • Well managed companies generally take a significant share of their earnings and reinvest them back into their business to fuel the company’s growth.
  •  Earnings Per Share (EPS):  This is an important figure to find out, and it is the basis of many other calculations.  It starts with the profits a company earns after taxes, bond interest, and preferred-stocks payments have been made.  This figure is then divided by the amount of common shares outstanding. 

    Example:  A company earns $10 million.  If it has 5 million shares outstanding then the EPS is $2.

 $10mil (earnings) 5 mil (shares outstanding) = $2 EPS

 

Things to look for:

  • How does the current EPS compare to the stocks historical performance?
  • How does it compare to professional analyst expectations?
  • Look for a company whose earnings "beat" analyst expectations.
  • Are the profits from routine operations or are they from a one-time occurrence, such as sales of a division or assets?  You should look for profits from routine operations.
  • Look for a company whose EPS in the latest quarter is higher, preferably much higher than the same quarter a year ago. 
  •  Price-Earnings Ratio (P/E) (aka: Multiple):  Many investors consider the P/E ratio to be the single most important measure of a company.  It shows you how much an investor is willing to pay for each dollar a company earns.  Companies with no earnings or losses do not have a P/E ratio.  The most frequently quoted P/E is a "trailing" P/E ratio, which is based on the previous 12 months.  Some analysts also forecast next year's estimated P/E ratio which is called a "forward" P/E ratio.  The Price-Earnings Ratio (P/E) is the price of a share divided by the Earnings Per Share (EPS) (see above).

For example:  If a stock is selling at $20 and has an EPS (Earnings Per Share) of $2 in the previous 12 months, it has a "trailing" (looking back) P/E ratio of 10.

 $20 (price per share) ÷ $2 (Earnings Per Share) = 10 P/E It is so important you generally can find a stock’s P/E ratio in newspapers and financial websites often next to the stock’s price.

 

 Things to look for:

  • How does the company's current P/E ratio compare to:  Its historical P/E the P/E of other companies in the same industry; how does it compare to the market in general such as the Dow Jones or S&P 500.
  • Investors usually are willing to pay more to own shares of a company whose earnings will out-pace its competition.
  • Some people look for companies with low P/E ratio if they expect a company to prosper in the future, or if its industry is projected to experience growth.  But make sure that you have good reason to expect the company to grow in the future.  A low P/E ratio could just be a sign of a poorly performing company.
  • Also look at "forward" P/Es based on analyst expectations, "Trailing P/E" only tell you what happened.

Example: If a stock is selling for $40 and pays $2 a year in profits its dividend yield is 5%.

 


Things to look for:

  •  Compare the dividend yield of a company to its competitors.  Dividend comparison varies by industry.
  • Has the company historically raised its dividends?
  • Look for companies with rising dividends and rising earnings.
  • If a company cuts its dividends this usually signals a problem.
  •  Return on Equity (ROE):  Explains how efficiently the company uses its money. Technically, it is the company’s net profit after taxes, divided by its book value.


Things to look for:
 

  • Return on equity that grows year after year.
  • Look for a company with a Return On Equity of 15% or higher.  The higher the better.
  • If the ROE is up and down, or just plain down, the company might have a problem with debt or profit margins.