• Create BookmarkCreate Bookmark
  • Create Note or TagCreate Note or Tag
  • PrintPrint
Share this Page URL



What This Book Will Do for You

Can you trust the financial reports you get from publicly listed companies?

No. Because the norm for reporting includes all sources of revenue, that norm is both inaccurate and unreliable. To develop accurate and dependable information, we need to make “core earnings” adjustments—the removal of revenue sources that are not permanent and not a part of the core business of the company. We also need to add in some expenses that are intentionally excluded from the standard financial statement, such as stock options expense. Only then can the numbers be considered reliable.

The problems of how numbers are reported have been widely publicized; but solutions are going to occur only slowly. This book is designed to explain and demonstrate a new approach to fundamental analysis. The concept is based on the idea that by making core earnings adjustments, we can arrive at a real picture of a corporation's operating profit or loss, the likely growth curve into the future, and the financial and operating strength and capitalization of the company.

The book has two sections. Part I (Chapters 1 through 5) is a summary of five specific and important techniques:

Core earnings calculations. The adjustment from reported earnings to core earnings is critical in order to begin your analysis with valid and relevant information. The major adjustments are projected pension income (net of interest expense), earnings from discontinued operations, income from sale of capital assets, and other nonrecurring and extraordinary items.

Why is it so important to go through these calculations and adjust the earnings reported in the audited financial statements? To identify stocks with likely growth prospects, we have to make sure that we are looking at the numbers that will define growth potential. Noncore numbers are not part of that growth equation, so they have to be adjusted. One of the problems in the industry today is that the GAAP system is slow to change, and even slower to recognize flaws in methods approved for use. The system—which has no central decision-making body, but is a collection of opinions, research, and publications of the AICPA, FASB, and dozens of other organizations—still recognizes noncore items for inclusion in the operations statement. This is changing, but only slowly. For now, we have to make our own adjustments to arrive at valid raw material for stock analysis.

Trend discovery. The second technique suggested in this revised approach to fundamental analysis is the process of discovering trends (again, based on core-earnings-adjusted results). In the traditional approach to fundamental analysis, we tended to accept audited numbers and indicators at face value and to make decisions without questioning the data. We propose here that the real discovery of the trend involves taking a different point of view, one more critical of the raw material itself. Three key trends serve as the basis for discovering the overall growth trend: sales/profits, capitalization, and PE ratio. These are by no means meant as a comprehensive range of analysis you will be likely to employ in picking stocks, but they are the leading indicators, and these in turn take us to insights about the nature of the company and its underlying strength or weakness.

Chapter 2 challenges this traditional method of looking at key fundamental indicators. Four observations for reevaluation are proposed:

  1. Core earnings adjustments are a necessary first step before any further analysis can be valid.

  2. Market price trends are short term and cannot be used for forecasting value. However, price volatility is a valuable and important technical tool for comparison of growth risk.

  3. All key trends should be subjected to confirmation by related fundamental and technical trends. This is the concept found in the original Dow theory applied to individual stocks rather than to an index of stocks.

  4. Finally, we need to move away from price-oriented indicators, which are short term and technical in nature, and begin developing sound methods for identifying growth potential using historical financial trends. We propose that the most revealing long-term trends are derived from financial results rather than from price and that, just as internal corporate experts use those trends to forecast sales and profits, we can use the same information to pick winning stocks.

Trend interpretation. Once we identify the nature of financial trends (and the need to adjust to core earnings), it also becomes possible to analyze companies on a realistic basis. This concept leads logically to how a company's audited financial statement can be studied and interpreted to judge and compare market risk.

Confirmation. The methods of confirming indicated trends add certainty to our forecasting, and this is at the heart of stock analysis. This chapter provides examples of how key indicators can be confirmed or questioned.

Confirmation is valuable in one of two outcomes. When an indicated trend is verified by other trends, you can proceed with confidence, knowing that the appearance of the original trend is probably correct. Of equal value is a contradiction in the confirming indicator. If the original trend implies one conclusion, but you cannot confirm it, then chances are that the apparent trend is misleading. This problem of analysis—the false lead—causes many miscues in the process of analysis, including the commitment of capital without adequate information. The confirmation process adds an element of certainty and advanced insight to important investment decisions.

Fundamental volatility analysis. Chapter 5 proposes that market risk should be based not on price volatility, but on volatility in the fundamentals. We tend to take comfort when revenues and earnings rise steadily from year to year; but in fact, that low volatility is not always possible, nor is it reasonable to expect with any certainty.

A study of fundamental volatility helps to quantify the effectiveness of corporate management, identify appropriate levels diversification among product or service segments, and gauge the levels of competitive strength for a particular company. Volatility may also serve not as a negative indicator of unsettled management, but as a symptom of growth itself. Thus, the interpretation of causes for fundamental volatility is one of the keys to picking long-term growth stocks. Compared with price volatility, a study of fundamental volatility is far more revealing.

In Part II, these techniques are expanded upon with specific and detailed examples. Chapter 6 examines the importance of investigation, which sets up the crucial step-by-step analysis of several listed companies, found in Chapter 7. In Chapter 8, we expand upon the detailed examples by showing how the numbers are interpreted. Chapter 9 concludes with an example of how to isolate stocks down to a handful of potential investment candidates based on a combination of indicators: core earnings adjustments, price volatility, and dividend record.

This new approach to stock analysis—in which a few key techniques are focused to validate information and to test it—are designed to ensure that stock selection can be based on actual fundamental tests and that, rather than serving only as historical and outdated information, those tests provide you with insight into likely growth patterns. The key to analysis is in the application of valid and verified raw material in a forward-looking program. The failure of some more traditional approaches is twofold. First, even so-called fundamental programs eventually revert to technical analysis, which may be unreliable because it emphasizes short-term price rather than long-term growth. Second, the use of fundamental information is flawed if it includes noncore earnings items or it is simply out of date.

The standard financial reports in the media focus primarily on price changes from day to day. Whether for stocks or index movements, little is reported in the press about the fundamentals, and for good reason. Price change is specific and immediate; it is easily conveyed in the form of a sound bite; and people understand what it means. The problem in this media approach is that short-term technical information (such as daily price movement) reveals nothing about the more important questions: How do you identify stocks that are going to outperform the market? What is the true nature of investment risk? And why are the financial numbers the real key to finding growth stocks? For answers to these important questions, we cannot depend on the daily news; we have to roll up our sleeves and take a new look at the numbers.

  • Creative Edge
  • Create BookmarkCreate Bookmark
  • Create Note or TagCreate Note or Tag
  • PrintPrint