Fundamental Analysis: Qualitative Factors - The Company
Fundamental analysis seeks to determine the intrinsic value of a company's stock. But since qualitative factors, by definition, represent aspects of a company's business that are difficult or impossible to quantify, incorporating that kind of information into a pricing evaluation can be quite difficult. On the flip side, as we've demonstrated, you can't ignore the less tangible characteristics of a company.
In this section we are going to highlight some of the company-specific qualitative factors that you should be aware of.
Even before an investor looks at a company's financial statements or does any research, one of the most important questions that should be asked is: What exactly does the company do? This is referred to as a company's business model – it's how a company makes money. You can get a good overview of a company's business model by checking out its website or reading the first part of its 10-K filing (Note: We'll get into more detail about the 10-K in the financial statements chapter. For now, just bear with us).
Sometimes business models are easy to understand. Take McDonalds, for instance, which sells hamburgers, fries, soft drinks, salads and whatever other new special they are promoting at the time. It's a simple model, easy enough for anybody to understand.
Other times, you'd be surprised how complicated it can get. Boston Chicken Inc. is a prime example of this. Back in the early '90s its stock was the darling of Wall Street. At one point the company's CEO bragged that they were the "first new fast-food restaurant to reach $1 billion in sales since 1969". The problem is, they didn't make money by selling chicken. Rather, they made their money from royalty fees and high-interest loans to franchisees. Boston Chicken was really nothing more than a big franchisor. On top of this, management was aggressive with how it recognized its revenue. As soon as it was revealed that all the franchisees were losing money, the house of cards collapsed and the company went bankrupt.
At the very least, you should understand the business model of any company you invest in. The "Oracle of Omaha", Warren Buffett, rarely invests in tech stocks because most of the time he doesn't understand them. This is not to say the technology sector is bad, but it's not Buffett's area of expertise; he doesn't feel comfortable investing in this area. Similarly, unless you understand a company's business model, you don't know what the drivers are for future growth, and you leave yourself vulnerable to being blindsided like shareholders of Boston Chicken were.
Another business consideration for investors is competitive advantage. A company's long-term success is driven largely by its ability to maintain a competitive advantage - and keep it. Powerful competitive advantages, such as Coca Cola's brand name and Microsoft's domination of the personal computer operating system, create a moat around a business allowing it to keep competitors at bay and enjoy growth and profits. When a company can achieve competitive advantage, its shareholders can be well rewarded for decades.
Professor Porter argues that, in general, sustainable competitive advantage gained by:
Just as an army needs a general to lead it to victory, a company relies upon management to steer it towards financial success. Some believe that management is the most important aspect for investing in a company. It makes sense - even the best business model is doomed if the leaders of the company fail to properly execute the plan.
So how does an average investor go about evaluating the management of a company?
This is one of the areas in which individuals are truly at a disadvantage compared to professional investors. You can't set up a meeting with management if you want to invest a few thousand dollars. On the other hand, if you are a fund manager interested in investing millions of dollars, there is a good chance you can schedule a face-to-face meeting with the upper brass of the firm.
Every public company has a corporate information section on its website. Usually there will be a quick biography on each executive with their employment history, educational background and any applicable achievements. Don't expect to find anything useful here. Let's be honest: We're looking for dirt, and no company is going to put negative information on its corporate website.
Instead, here are a few ways for you to get a feel for management:
1. Conference Calls
The Chief Executive Officer (CEO) and Chief Financial Officer (CFO) host quarterly conference calls. (Sometimes you'll get other executives as well.) The first portion of the call is management basically reading off the financial results. What is really interesting is the question-and-answer portion of the call. This is when the line is open for analysts to call in and ask management direct questions. Answers here can be revealing about the company, but more importantly, listen for candor. Do they avoid questions, like politicians, or do they provide forthright answers?
2. Management Discussion and Analysis (MD&A)
The Management Discussion and Analysis is found at the beginning of the annual report (discussed in more detail later in this tutorial). In theory, the MD&A is supposed to be frank commentary on the management's outlook. Sometimes the content is worthwhile, other times it's boilerplate. One tip is to compare what management said in past years with what they are saying now. Is it the same material rehashed? Have strategies actually been implemented? If possible, sit down and read the last five years of MD&As; it can be illuminating.
3. Ownership and Insider Sales
Just about any large company will compensate executives with a combination of cash, restricted stock and options. While there are problems with stock options (See Putting Management Under the Microscope), it is a positive sign that members of management are also shareholders. The ideal situation is when the founder of the company is still in charge. Examples include Bill Gates (in the '80s and '90s), Michael Dell and Warren Buffett. When you know that a majority of management's wealth is in the stock, you can have confidence that they will do the right thing. As well, it's worth checking out if management has been selling its stock. This has to be filed with the Securities and Exchange Commission (SEC), so it's publicly available information. Talk is cheap - think twice if you see management unloading all of its shares while saying something else in the media.
4. Past Performance
Another good way to get a feel for management capability is to check and see how executives have done at other companies in the past. You can normally find biographies of top executives on company web sites. Identify the companies they worked at in the past and do a search on those companies and their performance.
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.
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.
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. (To read more on takeover strategies, see The Wacky World of M&As.)
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.
Information on the board of directors of a publicly traded company (such as biographies of individual board members and compensation-related info) can be found in the DEF 14A proxy statement.
We've now gone over the business model, management and corporate governance. These three areas are all important to consider when analyzing any company. We will now move on to looking at qualitative factors in the environment in which the company operates.
Securities analysis that uses subjective judgment based on nonquantifiable ...
A financial statement that summarizes the revenues, costs and ...
Discounted cash flow (DCF) is a valuation method used to estimate ...
The degree to which an asset or security can be quickly bought ...
Profit margin is part of a category of profitability ratios calculated ...
A three-month period on a financial calendar that acts as a basis ...
Fundamental analysis is, at its core, all about understanding risks and recognizing good management. When a fundamental analyst ... Read Full Answer >>
Before you evaluate a company's capital employed, you first need to nail down a consistent, working definition of capital ... Read Full Answer >>
C-suite executives are essential for creating and enacting overall firm strategy and are therefore an important aspect of ... Read Full Answer >>
There is no easy way to conduct financial forecasting. All forecasting involves the technically impossible act of predicting ... Read Full Answer >>
Fundamental analysts normally start by examining the balance sheet. This is because the balance sheet is a snapshot of the ... Read Full Answer >>
In finance, fundamental analysis focuses on estimating a company's value based on the underlying factors that affect its ... Read Full Answer >>
The basic dividend discount model (DDM) creates an estimate of the constant growth rate, in perpetuity, expected for dividends ... Read Full Answer >>
A company's bottom line, also referred to as net income, is an important indicator of operational condition and can be used ... Read Full Answer >>
The efficient market hypothesis (EMH) is at odds with fundamental analysis because of its assumptions about the availability ... Read Full Answer >>
Purchasing a stock on margin is principally no different than purchasing a house through a mortgage loan. The macroeconomic ... Read Full Answer >>
The idea that stocks are consistently being priced and repriced at their fair value is the central assumption of the efficient ... Read Full Answer >>
Utility stocks have a unique place in the income-investing world. Known as a good hedge during hard times, utilities have ... Read Full Answer >>
Hedge funds use short selling to profit from stocks whose prices they believe are going to decline in value. A hedge is a ... Read Full Answer >>