Some companies these days have so many branches it can be hard to keep track of how they are performing. That's where Fundamental Analysis comes into play. Fundamental Analysis strips away all the extra investments and activities of a business, leaving you with the nucleus. The key to smart investing is to look at how a company did in its primary function, or else you might find yourself with a stock rotten to its core.
Introduction
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Okay, now back to Fundamental Analysis
In this chapter, we’re going inside. We’re going to look at what fundamental analysis is, and why it’s important for a company to have a solid core. We'll explain operating revenue and expenses, and how these numbers play into the bigger picture of valuation. Then we’ll get to cost of goods sold, another important business metric, and how it affects profitability.
And finally, EBITDA! EBITDA stands for Earnings Before Income Taxes, Depreciation, and Amortization. Businesses love to throw that term around, not just because it makes them sound like they know what they’re talking about, but also because it’s one of the best valuation tools available.
Fundamental Analysis and the Core Business
OK, Apple Computers—one of the biggest companies on the planet. Super successful. Ultra hip. Giant money spinner. And obviously, a company with a clear focus: designing and building high-quality information devices, like computers, and tablets, and smartphones.
Sure, Apple does other stuff—watches, music services, cloud computing, even self-driving cars. But making those information devices is the bread and butter of what Apple does. In fact, you might even say it’s…
The core of Apple!! (High five—you didn’t see that joke coming, did you?)
And that leads us to an important concept in fundamental analysis: the core business.
Core Business: Getting to the Heart of Things
The core business can be something of a fuzzy concept. Google, for example, makes a ton of money off its search engine—but it’s so heavily identified with other things, like the Android operating system, and that self-driving car it’s working on, and that weird set of glasses it developed…
Knowing what the core business is matters, though. Companies that get distracted from their core business can end up losing their way strategically. Investors that get distracted from it can be fooled by a company’s financial results: they don’t see that the company’s success in a peripheral business is temporarily masking a decline in its core business.
And knowing what the core business is helps you in analyzing a stock: it makes clear what you should focus on when determining what the stock’s long-term prospects are like. So let’s begin our analysis of the core business by looking at core business processes.
Core Business Processes
In every company, there are five key processes that need to be working well if the company is to succeed:
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Value Creation:Companies are in business to meet a demand. That means providing a good or service that consumers want.
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Marketing:You may have built the best mousetrap in the world—but if people don’t know about it, it’s not worth anything.
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Sales: No explanation needed here. (At least we hope.)
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Value Delivery: Getting that product or service into people’s hands is a big challenge—from managing supply chains to driving trucks. Mess it up and sales tank.
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Finance: You gotta spend money to make money. That means raising money through equity or debt.
So let’s see how this works. We’re going to use the example of a cupcake company—because we love cupcakes here at WSS, and we’re just a bunch of really super-sweet people—we’re going to start with Operating Profit.
Operating Profit and Fundamental Analysis
We all know what profit is: the money left over after you’ve added up all your expenses. But as simple as that definition is, in business things are more complicated—as you’re going to see. Let’s take a look at our cupcake shop’s operating revenue, expenses and—most importantly—profits!
Operating Revenue
We start with operating revenue.
In the cupcake business, you could generate revenue from a lot of different things: making cupcakes, selling recipe books in your stores, giving classes in cupcake making, catering to birthday parties, offering baking equipment for sale at every outlet. Whatever money you make is related to your core business, so it’s considered operating revenue.
But what if you sell an old warehouse where you stored supplies? The sale would count as revenue, but is it revenue from your core business? No. It’s a one-timer that doesn’t affect your cupcake and cupcake-related sales. It tells you nothing about how well your core business is doing, so it’s excluded from operating revenue.
Operating Expenses
The flip side is operating expenses. These are the expenses that you incur from everything related to the core business. All that flour, sugar, chocolate, parchment-paper cups, sprinkles, cupcake boxes, etc… No wonder cupcakes are so expensive!
But what about the legal costs that you incur when a customer SUES YOU because some baker accidentally mixed radioactive polonium into a batch of double-chocolate cupcakes for a giant family reunion, and 55 people got violently ill? Nah, not an operating expense. It’s a one-off. Not a regular cost of doing business.
Operating Profit
This one is dead easy.
Operating Profit = Operating Revenues – Operating Expenses
The higher the operating profit is, the better off your cupcake business is. It shows that your basic business is profitable and doesn’t rely on events like asset sales to make your balance sheets look good. (Some companies have been known to do that during tough times.)
Let’s say that you made $10 million this year from selling cupcakes. (Come on, this has to be a big company if you’re going to survive that polonium-related lawsuit.) You also sold a warehouse that netted you $500,000. On top of that, your cupcake company has a 20% stake in a life insurance company—which is kind of handy, because ever since that story about the radioactive cupcakes went viral, EVERYBODY is buying health insurance, and you earned $2 million in dividends this year. Finally, your operating expenses were $3 million.
So what’s your operating profit?
Well, the warehouse sale doesn’t count—it’s a one-off. And the dividends from the insurance company also don’t count. They’re not a one-off, but they’re also not revenue from your core business.
So your operating profit is $7 million: $10 million in operational revenue, minus $3 million in operational costs.
Now let’s look at another key measure of your core business: cost of goods sold.
Cost of Goods Sold
OK, this is just common sense, right? Cost of goods sold is…just, well…the cost of goods sold! Seriously, do accountants even waste ANY time on this?
Actually they do. That’s because in business, there are a lot of things that go into the cost of goods sold.
There are some pretty obvious things that make up the cost of those cupcakes you sell. All the materials, for example: the flour, the butter, the sugar. And the wages you have to pay: your bakers and cupcake designers are not going to work for free.
And the not so obvious…
But then there are things you might not have thought about. You’ve got to run your bakery, and that means paying for the lights, the heating, the air conditioning, keeping the ovens going—all your utilities.
And you also have inventory: you’ve got to keep huge amounts of flour and sugar and butter and yummy sprinkles on hand, so that you don’t run out and have to shut down production until you get a new delivery. That means storing it in a warehouse. (And not just any warehouse: you’re going to need big fridges for things like butter and eggs and anything else that’s perishable. See how hard it is to run a cupcake business?)
And then there’s depreciation. That’s not the depreciation in value of your cupcakes, because hopefully you’re selling them fresh and charging your regular full price. It’s the depreciation in the value of your buildings and equipment—and it’s special enough that we’ll deal with it as a separate item below.
What COGS doesn’t include is things like advertising, transportation, and sales force costs. They’re considered indirect costs because they are not associated with making the product.
How To Calculate COGS
It’s pretty hard to keep track of all those receipts and bills for a whole financial quarter, so how do you calculate COGS? Well, this is where accountants really get excited. Some smart accountant years ago figured out that all you have to do is compare inventory levels. Take the inventory at the start of the period, add whatever inventory purchases were made during that time, and subtract the ending inventory. Voilà (remember your French?): you now have the COGS for that time period.
For example,
let’s say you started the year with $1 million in inventory. (That’s a lot of eggs!)
You spent $500,000 on new inputs (flour, baking powder, chocolate)
You ended the year with $300,000 in inventory (way more sprinkles than you had bargained for).
Your COGS was $1 million + $500,000 – $300,000 = $1.2 million.
Depreciation and Amortization
As we mentioned above, depreciation is special enough to be treated on its own.
As your equipment “gets used up,” it loses value. Accountants call that loss depreciation, and under accounting rules you are allowed to deduct a certain portion of the cost of your equipment every year as an expense. Pretty simple, right?
But what about amortization?
Mathematically and theoretically depreciation and amortization are pretty much the same thing. The difference between them is that depreciation refers to physical assets like vehicles and equipment, while amortization refers to non-tangible assets like licenses and patents.
An Example of Depreciation
To illustrate this, let’s look at your cupcake business again. You’ve got a bank of industrial-sized fridges in your warehouse. You spent $300,000 on them, and that is how your accountant values them on your balance sheet.
Your accountant knows that these fridges are going to last 10 years, tops, because commercial-scale baking puts a lot of wear and tear on appliances. So the next year he values them at $270,000—he deducted 10%, or $30,000, from their value.
And he keeps doing that every year for another nine years, until at the end of 10 years the fridges are considered worthless because you have to replace them.
The most common method of doing this is called the straight line method, which we’ve shown above. It’s also the easiest method, because you just have to expense the same amount every year. Of course, if your fridges are still working, fine, keep ‘em—but on your books they are considered to have no value. You have just mastered Depreciation and Amortization.
Amortization works the same way. Take the cost of a licensing fee, for example, and deduct a certain percentage as a cost every year until you have to get another license.
And now we come to our favorite part, explaining a big acronym—EBITDA!
EBITDA
EBITDA is a major acronym that you will hear used by companies all the time in financial statements and business news. It stands for
And it tells you a lot about the financial health of a company. Specifically, it looks at the expenses required to run the business and tells you whether or not the business is profitable.
There is, however, a problem with that.
EBITDA is not regulated by the Generally Accepted Accounting Principles (GAAP). That means it is not always measuring the same thing from company to company, and accountants—who can get very creative—are able to “massage the numbers” to make an unprofitable business look profitable.
And there’s an even bigger problem: if you don’t have a background in accounting, it can be difficult to figure out where the accountants are being creative!
There is, however, a solution. And it doesn’t involve you going off to university to get a degree in commerce. Just use the other metrics we taught you in this course—DCF, NPV and IRR—in tandem with EBITDA. If they’re not all pointing you in the same direction, then that’s reason to delve a little further, or maybe avoid the stock altogether. Better safe than sorry.
How to Calculate EBITDA
But you can’t avoid EBITDA altogether. It is so commonly used in the investing world that you have to know what it is and how it’s calculated. And fortunately, it isn’t very complicated.
Essentially, you just take net income and add the interest, taxes, depreciation, and amortization back into it.
Intuitively that makes sense. Finding EBITDA this way is working backwards from profits to find how much the company made before the other factors were taken out. It gives you an idea of how well the company is keeping revenues ahead of costs.
So, back to our cupcake empire:
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Net income was $2.5 million this year.
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You paid $55,000 in taxes.
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You had interest charges of $20,000 (because you took out a big loan when you were just a little corner bakery, and you haven’t paid that loan off yet).
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On top of that, you recorded $120,000 in depreciation (stoves, fridges, trucks—they’re all taking a beating).
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You recorded $1 in amortization (licensing fees for an awesome cupcake recipe you got from a friend—seriously, you’re not going to pay more than $1 for a cupcake recipe, are you?).
That gives: EBITDA = Net Income + Taxes + Interest + Depreciation + Amortization
EBITDA = $2.5 million + $55,000 + $20,000 + $120,000 + $1 = $2,695,001
Remember—be conservative!
But that just raises the question: why would you want to “overlook” a cost like depreciation? It’s a cost, right, even though you may not be actually paying it in cash. (You will after 10 years, when those fridges finally conk out and your eggs go bad!)
And that gives you just a little sample of the limitations of EBITDA. Sure, it can be useful in telling you how profitable a company is, but it can also be used to deflect attention from what’s really going on with a company over the long term. Use it, but use it carefully. And that means looking at IRR, NPV, and DCF as well.
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