Naive Interpretations for Fundamental Analysis FA
Hey there :) Here you will read about palmy's naive interpretations of key figures for our Fundamental Analysis (FA) inside the 'Focus' model. Enjoy! Also make sure to open a focus site, like the one for AAPL to follow the explanations step by step.
Why naive?
Please take into account that we have developed a rule-based algorithm that makes certain assumptions and ignores industry or company specifics. You may not even agree on any of our generalizations, so it is definitively worth reading this article to check it :)
Accordingly, the algorithm is not sufficient to analyze a company on a peer or industry-specific basis. Nevertheless, the interpretation can be useful especially if you are familiar with our rules, which I would like to explain briefly and clearly below.
Categories
Our FA is structured into 6 categories.
- Valuation
- Profitability
- Financial Growth
- Leverage & Liquidity
- Per Share Metrics
- Financial Health
Interpretations
Our method for naive interpretations operates on three levels: Key Figure, Category, and Meta .
Each Key Figure has an associated rule that determines whether the interpretation is positive (+1) or negative (+0). The category interpretation is calculated by dividing the met rules within a category by the total number of rules for that category, resulting in a value ranging from 0 to 1.
To achieve a comprehensive understanding, we divide the aggregation of all categories by 6 (6 categories) to generate a final result representing the overall FA-Score, called "Meta" which also varies from 0 (D) to 1 (AA).
Rules
Clear presentation and explanation of our rules are vital for comprehension. It's important to note the inherent naiveness and generalization of our rules.
We've designed a format for easy reading and comprehension. If a rule makes sense to you or is clear without further explanation, feel free to skip the detailed breakdown.
-
Valuation (7 Rules)
-
This rule states that an EV/EBITDA value below 10 is considered healthy or even undervalued (+1). An EV/EBITDA above 10 may indicate an overvalued stock (+0).
-
A "Price/Earnings to Growth (PEG or P/EG) ratio" ratio that exceeds 1 implies that the stock's P/E ratio is disproportionately high compared to its expected earnings growth rate (+0). Anything below 1 will be considered as favourable, because a PEG of < 1 can imply an undervalued stock (+1).
-
A "Price-to-Book (P/B or PB) ratio" between 0 and 1 is generally considered favorable in the context of traditional valuation metrics (+1). Everything except that would miss the rule (+0).
-
A low "Price to Cash Flow (P/CF or PCF) ratio" may imply an undervaluation compared to its cashflows. We set the upper limit at 10 (+1). Therefore any PCF > 10 won't meet the rule (+0).
-
A "Price/Earnings (P/E or PE) ratio" of 5 or below might be a red flag, and we assume that it raises concerns about the quality of the company's earnings or potential risks that the market perceives (+0). On the other side we set an upper limit to 25, because aggressive growth expectations can be a risk of future profitability (+0). Therefore the rule is met, when the PE is between 5 and 25 (+1).
-
"PFCF (QOQ)" refers to the "Quarter over Quarter Price/Free Cash Flow (PFCF or P/FCF)" and it shows the difference between the most recent PFCF and the previous one (Quarter wise). If the observed difference surpasses 5%, the rule is considered satisfied, denoted by a score of +1. Conversely, discrepancies below 5% are not recognized as significant increases, yielding a score of +0.
-
A "Price/Sales ratio ('PS' or 'P/S')" between 0 and 1 is considered good (+1), because it may indicates that the market values the company's sales at a relatively low multiple compared to its stock price.
-
-
Profitability (4 Rules)
-
A "Gross Profit Margin (GPM)" below 50% is usually not desirable (+0) – though lower margins can still be sustainable for businesses with fewer production and operating costs. Every corporate with a GPM above 50% meets our naive rule (+1).
-
An increase in the "Quarter On Quarter Operating Profit Margin (OPM (QOQ))" is generally considered a positive sign (+1). It indicates that the company is becoming more efficient in managing its operating expenses relative to its revenue.
-
A "Return on Assets (ROA)" of over 5% is generally considered good and over 20% excellent (+1).
-
We've set a pretty strict range for the "Return on Equity (ROE)" rule to unbalance one-time gains, accounting adjustments, or other non-recurring event (potential for extraordinary high ROE's).
-
A "Return On Invested Capital (ROIC)" of 10% or higher is generally considered strong (+1). In any case, a company's ROIC must be higher than its WACC (Weighted Average Cost of Capital).
-
-
Financial Growth (6 Rules)
- Here, the analysis becomes more nuanced as we compare '(Δ QOQ)', signifying the difference ('Δ') between the last quarter-on-quarter (QOQ) metric and the one preceding it. In essence, we are examining the evolution of a specific metric over four consecutive quarters (2 x QOQ)
-
An increase of "Debt Growth (Δ QOQ)" has to be negative, as a generalized rule (+0). We assume that negative debt growth has to be positive (+1), e.g. -20%.
-
We think that Companies that have consistently increased their dividends tend to be more stable, higher quality businesses, which historically have weathered downturns and are more likely to have the ability to pay dividends consistently. Therefore a "Dividend Growth (Δ QOQ)" that is unchanged or positive will meet this rule (+1).
-
An increase of the "Earnings Before Interest and Taxes (EBIT)", betrayed in Δ QOQ has to be positive, because it suggests a stronger ability to cover interest expenses, which is essential for debt-servicing capacity (+1).
-
The Growth of "Earnings Per Share (EPS)" from a Δ QOQ perspective needs to be positive, because it means that a company is profitable enough to pay out more money to its shareholders (+1).
-
An increase of "Free Cash Flow (FCF)" is generally considered positive and is often viewed as a sign of a company's financial health and operational efficiency. Therefore the same perspective should count for our Δ QOQ view (+1).
-
When a corporate reports more revenue from a Δ QOQ perspective it implies growth & stability (+1)
-
Leverage & Liquidity (6 Rules)
-
A good "Days of Inventory Outstanding (DIO)" can vary based on the product, but on average, we assume one between 30 and 60 days as favourable average (+1).
-
The 'Days of Outstanding Sales (DSO)' should ideally be less than 40, then the rule is met (+1). Beyond this threshold, we posit that the company may be encountering too long delays in receiving payments on average.
-
A ratio of 1:1 would mean the company has the same amount of liquid assets as current liabilities. With an higher ratio the company could pay off current liabilities several times over. Both scenarios would meet our rule (+1), because they're considered as a positive sign for liquidity analysis.
-
We assume that a good asset turnover ratio is when it is above 1, since it implies that the company is fully utilising its owned resources to generate sales revenue. The higher the ratio, the better. It means that the company is earning more revenue by using its resources best.
-
A favorable inventory turnover ratio typically falls between 5 and 10 for most industries, signifying the ability to sell and restock inventory approximately every 1-2 months. Then the rule is met (+1).
-
This rule will assign +1 when a corporate's long-term debt should account for 40% to 60% of the total capitalization. Note that "Debt/Capitalization" is of course interchangeable with "Debt to Capitalization Ratio".
-
-
Per Share Metrics (3 Rules)
- Most of the 'Per Share Metrics' align with financial growth categories such as 'FCF' or 'Revenue.' The crucial distinction is in the 'Per Share' category, influenced by quarter-over-quarter ('QOQ') changes, as opposed to the '2x QOQ (Δ QOQ)' used in other financial growth metrics. Therefore, comparing both categories and examining their correlation could provide valuable insights for evaluating a stock.
-
We consider a 10% QOQ increase in 'Cash per Share' favorable, as it indicates either an improvement in cash flow or a more conservative accumulation of cash reserves per share in the latest 10-Q
-
An increase of "Free Cash Flow (FCF)" is generally considered positive and is often viewed as a sign of an improved liquidity, stability, debt management and corporate strategy. Therefore the same perspective should count for our QOQ view (+1).
-
Revenue growth on a "Quarter on Quarter (QOQ)" perspective has to be positive (+1).
-
Financial Health (4 Rules)
-
Setting the naive rule for the current ratio between 1.2 and 2 ensures a balanced financial approach, maintaining adequate liquidity to cover short-term obligations while promoting operational efficiency, financial flexibility for opportunities and challenges, and instilling confidence in investors through alignment with industry norms.
-
Establishing a naive rule for Debt/Equity between 1.5 and 2 aims to strike a balance, allowing for a reasonable level of leverage that supports growth and investment while mitigating excessive financial risk, thereby fostering a prudent capital structure.
-
Defining a naive rule for Debt/Assets between 0.3 and 0.6 seeks to establish a conservative capital structure, ensuring a moderate level of indebtedness that provides financial stability and operational flexibility, while minimizing the risk associated with excessive debt relative to total assets.
-
We think that a "Net Debt to Earnings Before Interest Depreciation and Amortization (Net Debt/EBITDA)" below 3 aims to maintain a manageable level of net debt relative to earnings before interest, taxes, depreciation, and amortization (EBITDA), ensuring financial prudence and indicating the company's capacity to meet its debt obligations through its operational performance.
-
Conclusion & Outlook
I hope the current number of rules hasn't overwhelmed or frustrated you. To make things more accessible, I've broken down the information into a more digestible format.
As this FA is entirely naive, you might be wondering about its alignment with industry or peer standards. We're actively working on a solution that automatically incorporates industry/peer group metrics statistics, enriching the interpretation.
If there's demand for it, we can expedite the process and finalize these improvements even sooner. Your feedback is valuable!
More Articles
Palmy Investing gives you the fastest solution to compare and analyse assets. From everywhere - Inside a single tab - Without a sign up. How does it work?