The Fundamentals Score

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Importance: Medium-High

Historical Predictive Power: Moderate

How it Relates to Returns: It is helpful for identifying bad companies, but does not predict market-beating returns.

Portfolios of companies with scores below 5 tend to perform very poorly. Portfolios of companies with scores of 5-6 underperform the S&P 500 slightly, but can have major winners or losers, so they should be considered carefully. Portfolios of companies with scores of 7+ tend to match the S&P 500 over long periods.

Historical Results - Performance of portfolios of companies by Fundamental Score

Fundamentals Score Performance

What it is: Ten basic pass/fail tests which together give a sense of whether a company has a strong foundation to pay its bills and survive.

How to use it: Basic: Look for scores of 7 or higher to avoid bad companies Advanced: Look at individual pass/fail marks to find possible problem points for deeper investigation.

Watch out for: Failed Fundamental Tests - If a company fails one, check some of its peer companies to see if they fail too (eg. many tech stocks do not pay dividends). If a company is different than its peers, find out why.


The Ten Fundamental Score Tests: In Detail

There are plenty of publicly traded companies in the world. Unless you have very specific knowledge and years of experience studying successful turnarounds of dying companies, you should be buying good businesses. The following ten tests are very simple, and they will help you steer clear of bad companies.

Test 1: Earnings per share have been growing during the past 10 years

Look at the historical earnings per share of a company and see if the trend is up or down. If the trend is down, be skeptical of the company. For example, Procter and Gamble’s (PG) earnings increased over the past 10 years, and Barnes and Noble's (BKS) decreased, as seen in the graph below:

PG EPS Diluted (Quarterly) Chart

PG EPS Diluted (Quarterly) data by YCharts

Test 2: Revenue has grown during the past 10 years

Look at graphs of revenue over time and make sure that there is an upward trend. Declining revenue may be a sign of falling market share or a shrinking industry.

Test 3: Five Year Average Return on Equity is greater than 5%

Return on equity (ROE) is the amount of income a company earns by investing shareholder's money. Higher ROE shows more efficient use of assets.

This test requires some calculations (unless you have a paid subscription, in which case these tests are calculated automatically). For the previous five years, note the Net Income from financial statements. Then take the Shareholder’s Equity numbers for the past five years from the Balance Sheet. Now, computing ROE for the past 5 years is simple. Just divide Net Income by Shareholder’s Equity for each year.

Finally, average those 5 years of ROE, and check to make sure that it is greater than 5%. If so, the company has provided some returns based on equity investment over the past five years.

Test 4: Minimum Gross Margin is greater than zero

If a company has a gross margin less than zero, that means that the company is selling its products below cost, which is bad business. Very few companies will fail this test, but it is a good check.

Test 5: Book Value per Share growth is greater than zero

You can approximate this test quickly by looking at the graph of Book Value per Share. Like the Earnings Per Share and Revenue growth tests, look for increasing numbers over the years.

Test 6: Current Ratio > 1

The current ratio test roughly answers the question: can the company pay off all of its debts this year if it gains no new sales or funding?

There are some companies that can survive indefinitely with a current ratio of less than 1 - Walmart is an example. For most companies, when an investor sees a current ratio of less than 1, the first thought should be: can this company pay its short term bills? Giving money to the company is not extremely different from giving money to a gambler who is already in the hole.

Hence, when a company has a current ratio of less than 1, be careful. The company should have a good reason for being that low. If you can’t find it, it’s safest to avoid the company.

Test 7: The company has not missed a dividend payment

Companies that pay dividends tend to be healthy companies. The reason is simple: if the company were worried about its future, it would conserve cash. Hence, companies that have paid dividends continuously over a long period of time have proved that they can avoid financial problems.

However, if a company has never paid a dividend, there should be a good reason. Specifically, the firm's managers need to prove to you that they can earn better returns investing their excess cash than you can investing it by yourself. If they can't find profitable projects, they should pay their cash out to you so you can invest it yourself.

If the company paid a dividend but then stopped, the company needs to have a good reason for stopping, and more importantly, a compelling reason that they will begin to pay dividends again soon.

Test 8: Debt to Equity ratio < 13

It is smart to be skeptical of companies that take on too much leverage (debt relative to their equity). Taking more debt increases the swings of a stock, both up and down, increasing the risk of the company to shareholders.

Banks that were battered during the financial crisis had huge debt to equity ratios going in, and paying attention to this fundamental test would have helped investors to steer clear of the risk of buying those companies.

Test 9: Average cash flow over the past 10 years is greater than zero

If a company earns negative cash flows for a number of years, watch out. A business that continuously loses cash is like a pile of feathers in a hurricane - it won't be around for long.

The young growing businesses will sometimes have negative cash flows as they invest in new assets. However, these companies have a very limited history, and a prudent investor tends to base future projections on the historical record rather than on speculation. Hence, the young company, though it may be one of the few companies that experiences amazing growth, is a very risky bet.

Other companies with negative cash flows might be experiencing temporary hard times. Sometimes the company will turn out to be a dying business, and other times it is preparing for a turnaround and hence therefore could be a phenomenal investment. If you want to do your homework, take a look at these special cases. If you want to spend less time choosing your investments, it is safest to avoid these types.

Test 10: Long term debt is less than 5x net income

This test insists that a company be capable of paying off its long term debt in less than five years at recent levels of income. Five years is an arbitrary number, but based on the studies of Benjamin Graham, it is a reasonable cut-off for most investors.

This is one of the weaker tests that we run, because there are a fair number of companies that can manage higher debt levels. Companies with very stable revenues, like Philip Morris (PM), have maintained debt at 7x net income for years, while still managing to pay a dividend. Therefore, be aware that this test, if failed, raises a yellow flag as opposed to red. It should be investigated, but in many circumstances, justification for the high debt levels should be easy to find.

Summary

An intelligent investor is searching for companies that have great long-term prospects. These tests are an excellent screen to find such companies.

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