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Robert Abbott
Robert Abbott
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Value Investing: Financial Statements

How security analysis begins with a review of the financial statements

January 17, 2020

Security analysis need not be a complicated subject, once you understand the context.

That came from Blaine Robertson in chapter six of “Value Investing: A Comprehensive Beginner Investor’s Guide.”

As he explained, security analysis is the use of publicly available data to analyze and evaluate stocks and other assets, as well as warrants and the debt of corporations. The analysis allows investors to determine the value of that security, and therefore to make better buy and sell decisions. There are three types of assets that can be valued: equities, debt securities (such as bonds) and derivatives (such as stock options).

Robertson also told us there are three types of security analysis:

  • Fundamental: Focused on business issues and data from financial statements and elsewhere.
  • Quantitative: Using indications coming from both technical analysis and financial statements.
  • Technical: Robertson wrote, “Technical analysis enables financial experts to analyze and make fairly accurate predictions regarding future price trends by using data from the past.” I would add a couple of thoughts: First, be skeptical about the “fairly accurate predictions” until someone can show you supporting evidence. Second, technicians focus on just a couple of data sets: Prices and trading volume. Third, this data is put into charts, to visualize stock valuations and to search for recurring patterns.

Financial statements

As Robertson has written, without financial statements, security analysis is impossible. They are the official record of a company’s activities over a specific past period, and available to the public, including all investors.

Essentially, a company’s financial statement shows readers the source of its income, the amounts that were spent to generate that income and the resulting profit or loss. The statement comprises three sub-statements, which are discussed below:

Balance sheet

This contains a list and values for:

  • Assets.
  • Shareholders’ liabilities.
  • Shareholders’ equity.

Assets can be anything from cash in a bank account to the factories used to build products. Some assets are physical entities and called tangible assets, while others are non-physical and called intangible assets.

Liabilities are debts or obligations taken on by a corporation; they can also be tangible and intangible. They include loans from banks, salaries of employees, taxes owed to the government and other obligations.

What’s left after the liabilities are subtracted from the assets is shareholders’ equity. Also known as “net worth,” it tells shareholders how much would be left if the company had sold off all its assets and ceased operations on a specific date.

Importantly, shareholders’ equity also includes the capital contributed by investors. Robertson explained that the money (capital) invested in a company’s stock, in combination with its losses and profits, is shareholders’ equity. If there are profits, they may be distributed in the form of dividends.

Income statement

The author used a helpful analogy to explain the function of the income statement. He referred to it as a set of stairs:

  • At the top is the total (gross) revenue of the company.
  • Expenditures are deducted on one or more stairs.
  • The bottom step shows how much the corporation earned (or lost) after all expenses were deducted from all revenue.

Note that expenses include not only operating costs, but also depreciation and amortization. The latter refers to the periodic (usually annual) costs of an expenditure that is spread over multiple years. Interest expenses are also listed here, as is income earned from interest. And taxes are also shown in the income statement.

Finally, we see net income and the company’s earnings per share, which are calculated by dividing net income by the number of outstanding shares. From this ratio, investors will learn how much they earned for each share they own.

Cash flow statement

Money comes in. Money goes out. You can find out in what proportions by studying the cash flow statement. Robertson pointed out that while earnings per share in the income statement tells you whether a company made a profit, the cash flow statement “takes it a notch higher.” That is, it can tell you whether the company was able to generate more cash than it paid out. It does that by providing data for three sets of activities.

In the operating activities section of the cash flow statement, the company shows how much of its net income came from operations, i.e. the company’s actual business. That is done by removing non-cash items from net income. One of the biggest non-cash items is often depreciation.

The investment activities section will show events such as the purchase of factories, equipment and property, as well as money put into investment securities. Consider a case in which the company buys a piece of property: cash will be exchanged for a piece of property that can be used to expand the company’s business.

Financing activities is the third type. It involves cash being received by the issuance of bonds or new shares, as well as money received from bank loans. On the other hand, cash flows out of a company when it repays a bank loan or buys back its own stock.

Conclusion

In this chapter, Robertson has provided an overview of securities analysis and the data needed to do it. That data comes from a corporation’s publicly accessible financial statements.

Within the financials are three main sections: the balance sheet, the income statement and the cash flow statement. The three sections complement each other and, taken as a whole, provide a comprehensive look at what a company has done in the previous period (quarter or year).

That financial information, when analyzed in detail and taken in context, will provide investors with significant assistance in making key decisions.

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About the author:

Robert Abbott
Robert F. Abbott has been investing his family’s accounts since 1995 and in 2010 added options -- mainly covered calls and collars with long stocks.

He is a freelance writer, and his projects include a website that provides information for new and intermediate-level mutual fund investors (whatisamutualfund.com).

As a writer and publisher, Abbott also explores how the middle class has come to own big business through pension funds and mutual funds, what management guru Peter Drucker called the "unseen revolution."

Visit Robert Abbott's Website


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