Know the Fundamentals

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Know the Fundamentals

A main principle of Peter Lynch’s stock-picking approach is to focus only on the company’s fundamentals and not the market as a whole. Lynch doesn’t believe in predicting markets, but he believes in buying great companies—especially companies that are undervalued and/or underappreciated. One might say Lynch advocates looking at companies one at a time using a "bottom up" approach rather trying to make difficult macroeconomic calls using a "top down" approach.

Read the financial statements!

Lynch believes that investors can separate good companies from mediocre ones by sticking to the fundamentals and combing through financial statements to find profitable firms with solid business models. He suggests looking at some of the following famous numbers, which happen to be many of the same numbers that stock analysts such as those at Morningstar look for.

Percent of sales

If your interest in a company stems from a specific product, be sure to find out if it represents a meaningful percent of sales. It doesn’t make sense to remain interested if this number is inconsequential.

Year-over-year earnings

Look for stability and consistency in year-over-year earnings. In the long run, a stock’s earnings and price will move in tandem, so look for companies with earnings that consistently go up.

Earnings growth

Make sure a company’s earnings growth reflects its true prospects. High levels of earnings growth are rarely sustainable, but high growth could be factored into a stock’s price.

The P/E ratio (Lynch’s favorite metric)

Think of the P/E ratio as the number of years it will take the company to earn back your initial investment (assuming constant earnings). Keep in mind that slow growers will have low P/E ratios and fast growers high ones. It is particularly useful to look at a company’s P/E ratio relative to its earnings growth rate (PEG ratio). Generally speaking, a P/E ratio that’s half the growth rate is very attractive, and one that’s twice the growth rate is very unattractive. Avoid excessively high P/E ratios and remember that P/E ratios are not comparable across industries. However, comparing a company’s current P/E ratio with benchmarks such as its historical P/E average, industry P/E average, and the market’s P/E can help you determine if the stock is cheap, fully valued, or overpriced.

The cash position

Look for a company’s cash position on the balance sheet. A strong cash position affords a company financial stability and can represent a built-in discount for investors in the stock.

The debt factor

Check to see if the company has significant long-term debt on its balance sheet. If it does, this could be a considerable disadvantage when business is good (can’t grow) or bad (can’t pay the interest expense).

Dividends

If you are interested in dividend-paying firms, look for those that have the ability to pay out dividends during recessions and a long track record of regularly raising dividends.

Book value

Remember that the stated book value often bears little relationship to the actual worth of the company, because it often understates or overstates reality by a large margin.

Cash flow

Always look for companies that throw off lots of free cash flow, which is the cash that’s left over after normal capital spending.

Inventories

Make sure that inventories are growing in line with sales. If inventories are piling up and sales stagnating, this could be an important red flag. Inventories are particularly important numbers for cyclical firms.

Pension plans

If a company has a pension plan, make sure that plan assets exceed vested benefit liabilities.