Fundamental balance sheet analysis is an integral part of the investment process. Prior to purchasing a particular stock, one of the first steps involves dissecting a corporation's financial statements to determine the firm's financial health. For example, a growing debt burden combined with a stable or even declining cash position could serve as a potential signal of overleveraging. Similarly, a situation in which a company shows strong net income growth, yet consistently fails to demonstrate an appreciating cash balance, may be a red flag of earnings manipulation. (Corporate fraud comes in many varieties. Learn to spot a crook; read Top 8 Ways Companies Cook The Books.)
TUTORIAL: Introduction To Fundamental Analysis
In order to properly examine the balance sheet for indicators of strength, weakness or potential fraud, the financial documents must be studied as a whole. Adjustments in accounting policies, modifications to operations and historical balance sheet comparisons all provide vital quantitative measures to assess the financial strength of a company. While numerical figures such as ratios and revenue forecasts are undoubtedly vital to the investment decisions, qualitative analysis offers another useful tool. (To learn more about analyzing financial positions, check out Reading The Balance Sheet.)
Fundamental Analysis: Qualitative Factors
Various qualitative factors can be easily attained from public information about the company of interest. A proper system of corporate governance that adheres to principles of integrity and transparent disclosures will mitigate the risks of fraudulent behavior. Furthermore, a valid system of checks and balances whereby independent third parties assess the integrity of corporate financial statements and monitor management's behavior are correlated with positive long-term stock returns. (To learn more about using qualitative factors to evaluate a company, read Qualitative Analysis: What Makes A Company Great.)
Other qualitative considerations could include how well the company adapts to social, technological, economic and political change. Firms with strong political connections may often be severely crippled once this support system is removed. Similarly, if a company is entirely dependent on a current social phenomenon (such as a fad) or a single technology, changes in these variables may cripple the firm. This type of analysis is often more difficult than analysis based on fundamentals because it requires creating hypotheses that cannot easily be answered.
Porter's five-force framework is a qualitative tool that applies to investment analysis. The framework helps analyze a firm's competitive stance in its industry. Porter's forces examine industry-specific conditions and help investors determine how well a corporation is positioned to adapt to changes in its target market.
Michael Porter's analysis serves as an alternative to Albert Humphrey's more common SWOT (strengths, weaknesses, opportunities, threats) model.
Porter's five forces:
- The threat of substitute services or products
- The threat of increased competition from rivals in the market
- The threat of new entrants into the market
- The bargaining power of suppliers
- The bargaining power of customers
Using these forces requires a solid understanding of the general industry/market, corporate business model and an appreciation for how the business can adapt to changes in market conditions. Basically, investors must analyze how a company can respond to the underlying threats. For example, it's common for a company to rank high in terms of competitive resistance on four forces and fail horribly on the fifth. Inevitably, determining how such a scenario would affect an investment's appeal is up to the investor. (Studying the market involves more than just reading financial statements. To learn to predict the direction of the market, read our tutorial on the Basics Of Technical Analysis.)
Threat of Substitute Product or Services
The threat of substitute products or services arises when customers can easily switch to alternative products (not necessarily alternative brands). For example, in a society that experiences drastic population growth, people might begin substituting their method of primary transportation from motor vehicles to either bicycles or public transit. Such changes in behavioral patterns would hinder the performance of the automobile industry.
However, to determine whether such a threat is realistic, various considerations must be made such as switching costs and the practicality of alternative products. In the previous example, if most individuals generally commute short distances on a day-to-day basis, bicycles could become a realistic threat to car makers. On the other hand, if the average daily distance one must travel is significant, people may be less inclined to switch to either buses or bikes.
Threat of Increased Competition From Rivals
Market saturation will often prevent a single player from gaining an overriding sales advantage and experiencing a surge in revenue. This internal threat is present in almost every industry that is not dominated by a monopoly. When analyzing the sort of threat that competition imposes, a wide variety of factors must be considered, such as brand equity, market position, advertising expertise and technological innovation. In many situations, the largest player in industry may become obsolete if it is lacking in the traits that ensure a stable and ongoing competitive edge.
Two common metrics used to determine the competitiveness of a market are the Herfindahl-Hirschman Index (HHI) and the concentration ratio. While the HHI measures market concentration and the level of competition, the concentration ratio provides a measure of the percentage of total market share held by the largest companies in the sector.
Threat of New Entrants
Barriers to entry are one of the most crucial components of Porter's framework. Barriers to entry can exist in the form of patents, substantial capital requirements, government regulations, access to a proper distribution network and technological expertise. Essentially, new entrants into a market will have to overcome multiple barriers if they are to compete with the already established companies. If the industry requires significant initial capital expenditures, smaller firms will simply be unable to enter the market. (Learn more about barriers to entry in Economic Moats: A Successful Company's Best Defense.)
Quite often, a firm will be the first on the market with an innovative technology or service that either automatically creates or revolutionizes the way business is done in a particular market. Unless there are firm barriers to entry, competitors can easily enter the market and replicate the prosperous firm's business model, thus diminishing the original company's returns. When entry barriers are lacking, those companies already in the industry will see their margins reduced and experience a subsequent share price decline as competition forces the convergence to normal profit levels.
Bargaining Power of Suppliers
The threat of disproportionate supplier bargaining power is typically a problem for smaller companies that are exclusively dependent on the inputs provided by one seller. For example, if a restaurant that specializes in unique dishes is only able to purchase the ingredients from a single provider, that supplier can easily increase the prices it charges. This will either decrease margins for the restaurant, or the restaurant will have to pass the additional costs of the ingredients on to its diners. (One of the main factors that determine pricing is the law of supply and demand. Learn more in our tutorial, Economic Basics: Demand and Supply.)
Large retailers such as Wal-Mart and Target are generally not at the mercy of their suppliers since they have access to a wide distribution network. Smaller niche businesses, however, may face a realistic threat of price hikes from suppliers. Gaining access to this type of information - who a business's suppliers are and what the existing relationship between the buyers and sellers is – usually requires extensive research.
Bargaining Power of Customers
When Wal-Mart and Target are viewed as the customers of a transaction, they exert a substantial amount of buying power. Many businesses are dependent on large department/retail stores to continue purchasing from them – therefore buyers can negotiate favorable price contracts and minimize the revenue potential of their suppliers. This threat is the opposite of the bargaining-power-of-suppliers concern.
Similar to the basic portfolio theory, which states that investors should diversify their holdings in order to minimize their exposure to any one security, safe companies should not be entirely dependent on a single customer. If one customer does not renew its contract, for example, this should not be enough to bankrupt the supplier. Having a diverse customer base is key to mitigating this threat.
The Bottom Line
Porter's analysis framework defines the important criteria to determine the stability of a corporation. High threat levels typically signal that future profits may deteriorate, and vice versa. For example, a hot firm in a growing industry might quickly become obsolete if barriers to entry are not present. Likewise, a company selling products for which there are numerous substitutes will not be able to exercise pricing power to improve its margins, and it may even lose market share to its competitors.
The qualitative measures introduced by Michael Porter in Porter's five-force framework allow investors to draw conclusions about a corporation that are not immediately apparent on the balance sheet, but will have a material impact on future performance. Although quantitative factors such as the price/earnings and debt/equity ratio are often the primary concerns for investors, qualitative criteria play an equal role in uncovering stocks that will provide long-term value. (For related reading, take a look at 3 Secrets Of Successful Companies.)