The Very Basic of Fundamental Analysis
³ Fundamentals: Quantitative and Qualitative
³ Quantitative Meets Qualitative
³ The Concept of Intrinsic Value
³ Criticisms of Fundamental Analysis
³ Conference Calls & Management Discussion and Analysis (MD&A)
³ Ownership and Insider Sales & Past Performance
³ Financial and Information Transparency & Stakeholder Rights & Structure of the Board of Directors
³ Industry Growth & Competition
³
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.
The Very Basic of Fundamental Analysis
³ Fundamentals: Quantitative and Qualitative
³ Quantitative Meets Qualitative
³ The Concept of Intrinsic Value
³ Criticisms of Fundamental Analysis
³ Conference Calls & Management Discussion and Analysis (MD&A)
³ Ownership and Insider Sales & Past Performance
³ Financial and Information Transparency & Stakeholder Rights & Structure of the Board of Directors
³ Industry Growth & Competition
³
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.
The Very Basic of Fundamental Analysis
³ Fundamentals: Quantitative and Qualitative
³ Quantitative Meets Qualitative
³ The Concept of Intrinsic Value
³ Criticisms of Fundamental Analysis
³ Conference Calls & Management Discussion and Analysis (MD&A)
³ Ownership and Insider Sales & Past Performance
³ Financial and Information Transparency & Stakeholder Rights & Structure of the Board of Directors
³ Industry Growth & Competition
³
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.
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.
The Very Basic of Fundamental Analysis
³ Fundamentals: Quantitative and Qualitative
³ Quantitative Meets Qualitative
³ The Concept of Intrinsic Value
³ Criticisms of Fundamental Analysis
³ Conference Calls & Management Discussion and Analysis (MD&A)
³ Ownership and Insider Sales & Past Performance
³ Financial and Information Transparency & Stakeholder Rights & Structure of the Board of Directors
³ Industry Growth & Competition
³
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
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.
The Very Basic of Fundamental Analysis
³ Fundamentals: Quantitative and Qualitative
³ Quantitative Meets Qualitative
³ The Concept of Intrinsic Value
³ Criticisms of Fundamental Analysis
³ Conference Calls & Management Discussion and Analysis (MD&A)
³ Ownership and Insider Sales & Past Performance
³ Financial and Information Transparency & Stakeholder Rights & Structure of the Board of Directors
³ Industry Growth & Competition
³
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.
