Fundamentals
A few basic fundamental metrics.
Good fundamentals do not make a good investment on their own. The fundamentals can help you understand the business and formulate an opinion on the price and business.
1 · Profit, and cash
The income statement records profit as it is earned. The cash flow statement records money as it moves. Both accounting profit and cash flow are worth understanding.
One measures profit, the other measures cash, and they are built separately on purpose
The income statement records revenue when it is earned and costs when they are incurred. The cash flow statement records money actually moving, in three sections. Net income appears in both only because the operating section is customarily presented by starting there and working back toward cash.
| Measure | What it is | What it hides |
|---|---|---|
| Revenue | What customers paid | Everything about what it cost to earn |
| Gross profit | Revenue less the direct cost of what was sold | The cost of running the company around it |
| Operating income · EBIT | Profit from operations, before financing and tax | How the business is financed, and what it pays to borrow |
| EBITDA | Operating profit with depreciation and amortization added back. Derived, not reported | That worn-out assets usually have to be replaced with cash |
| Net income | What the accountants report to shareholders | Timing choices, one-time items, and non-cash charges |
| Cash from operations | Cash the business actually generated, before investing and financing | What it costs to keep the assets running, which sits in investing |
| Free cash flow | Cash from operations less capital spending. Derived from two sections, so definitions differ | How fairly the spending called “maintenance” was estimated |
Operating income persistently far above free cash flow usually means the business consumes capital to stand still. Net income far above cash from operations can mean growth in receivables or inventory, or something less benign. The two statements are prepared separately for exactly this reason: a business can report a profit it has not collected, and collect cash it has not yet earned. Neither statement explains why. A dollar spent widening an advantage and a dollar wasted leave the same mark, and only the years that follow tell them apart.
2 · Return on capital
What the business earns on the capital already in it, and what it earns on the next dollar put in.
| Measure | The question it answers | What to watch |
|---|---|---|
| ROC · ROIC | For every dollar tied up in the business, how much profit comes back each year? | The trend across a decade, not one year |
| ROE | What do shareholders earn on the equity they own? | Borrowing can lift it; read it beside the debt |
| ROCE | What does all capital employed earn, debt and equity together? | Favored by investors who want borrowing out of the answer |
| ROIIC | What does the business earn on capital invested from here? | Falling incremental returns while growth continues |
| Return vs cost of capital | Is growth creating value or consuming it? | Growth funded below the cost of the money |
A high return on the capital already in place tells you what a business has built. It says nothing about where the next dollar goes, and a company can earn well on everything it owns and have no runway left to invest more, which limits how long those returns run. The incremental number is the one that prices growth. Joel Greenblatt built a formula on return on capital and earnings yield together, ranking businesses on the two and holding each for roughly a year before re-ranking and replacing it. The annual turnover is how the method handles durability: instead of forecasting how long a high return lasts, it re-ranks and lets the list move on. The cost of that answer is turnover itself, in trading and in tax.
The return on the next dollar is what growth is worth
Two businesses with the same return on their existing capital. One still earns that rate on new money; the other has run out of places to earn it.
3 · Growth, and what kind
Three things to separate: how fast, how steadily, and where it came from.
| Dimension | Read it as | Worth most when |
|---|---|---|
| Rate | Revenue, earnings, and free cash flow growth, per share | All three move together |
| Shape | How steadily it arrives, year after year | It holds through a recession and a rate cycle |
| Source: sold more | More customers, more volume | Always. This is growth earned inside the business |
| Source: priced more | The same units at higher prices | Customers stay, which is a test of the moat |
| Source: bought | Acquisitions | Small and often, at sane multiples, in businesses the buyer already understands, with the people kept |
| Source: financed | Funded by new shares or new debt | Rarely. Part of it belongs to whoever funded it |
Two companies can average the same growth over a decade, one arriving in a steady line and the other in two enormous years and four flat ones. Linearity is generally what I like to see, because a business customers buy from on a schedule is easier to underwrite than one they buy from when they feel like it. Cyclicality does not rule a business out on its own. It has to be understood, and then accounted for in what you pay and how much you own.
Acquired growth is the one worth slowing down on, because good acquirers and bad ones look the same on a growth chart and nothing alike ten years later. The disciplined acquirers ran different businesses in different eras and bought the same way: they paid a price they could defend, they bought things they intended to keep, and they left the people who built them in charge: valuation discipline, a return on capital or equity they held themselves to, and the advantages that come from sometimes extreme decentralization.
An acquirer’s own return on capital, followed across a decade of buying, tells you if the deals added a business or only added revenue. Returns that hold up mean the price was right and the thing bought was real. Returns that drift down while revenue climbs mean growth was purchased rather than earned, and the goodwill sitting on the balance sheet is the unpaid bill.
How long any of it lasts is a question about competition, and it belongs to What a Moat Is.
4 · Margins and turns
Return on capital is margin multiplied by turnover. A business can earn its return either way.
| Measure | Shows | Compare against |
|---|---|---|
| Gross margin | Pricing power | Its own history; direct competitors |
| Operating margin | Efficiency of the whole model | The industry, and the market |
| Asset turnover | How often capital cycles through the business in a year | The business model it belongs to |
| Market share | A margin being defended, or harvested | Margin direction at the same time |
A margin that holds through a recession says more than a higher one that fell. Watch it against market share: rising together usually means customers are choosing the product for something other than price. Margin rising while share falls often means the business is harvesting an advantage rather than defending it.
Two businesses can earn the same return by opposite routes
Return on capital is margin times turnover. A fat margin on slow-moving goods and a thin margin on fast-moving ones can land in the same place.
5 · The balance sheet, across a decade
The income statement covers one year. The balance sheet covers every year so far.
| Line | Ask | Warning sign |
|---|---|---|
| Assets | Which of these earn a return, and which just sit? | Growing assets, flat or falling returns |
| Debt | How steady are the cash flows underneath it? | Rising debt funding flat operating income |
| Goodwill | What premium was paid for what was bought? | Large write-downs, which admit the price was wrong |
| Cash | Is it working, waiting, or trapped offshore? | Cash held while shares are issued |
| Working capital | Is the business funding its customers, or funded by its suppliers? | Receivables growing faster than revenue |
Debt does one thing in both directions: it makes a good year better and a bad year worse. How much a business can carry depends on how steady it is underneath. A toll road can hold debt a young software company cannot.
6 · Per share, and the share count
A business can grow its earnings and shrink your share of them in the same year.
| Watch | Because |
|---|---|
| Share count, over ten years | The cleanest test of a buyback being real rather than cosmetic |
| Buyback pace | Most companies buy most heavily near peaks |
| Price paid in buybacks | Repurchasing below worth transfers value to holders who stay; above it does the reverse |
| Share-based compensation | Buybacks that only offset new issuance return nothing |
| EPS growth vs net income growth | The gap is the share count doing its work, in either direction |
One operator bought in a large share of his company’s stock while it was cheap and issued stock while it was dear. Most companies do the opposite, buying hardest after a long run of good news. Capital Allocation takes up that subject on its own.
7 · What the price already assumes
Everything above is history. A price is a claim about the future.
| Measure | Most useful compared with | Where it falls short |
|---|---|---|
| P/E, forward and trailing | Its own history over five and ten years, the market, and peers | Earnings can be managed, and it ignores debt |
| P/S | Its own history, for a business with volatile or absent earnings | Says nothing about whether the revenue is profitable |
| P/OCF | Its own history and close peers | Ignores what must be reinvested to keep the cash coming |
| Free cash flow yield | Similar businesses, the industry, and the market | Distorted in years of heavy investment or unusual working capital |
| EV/EBIT | Similar businesses, since it accounts for debt and cash | EBIT still carries accounting judgment |
| EV/EBITDA | Capital-intensive businesses and across capital structures | Treats depreciation as if the assets never need replacing |
| Price to book | Similar asset-heavy businesses, where book means something | Near useless where the value is intangible |
| Implied expectations | The growth and margins the price requires to make sense | Takes the most work, and rewards it |
Michael Mauboussin and Alfred Rappaport put implied expectations at the center of Expectations Investing: read the price backward to find what it assumes, then ask what would have to be true for the business to do better than that. Most of the time the price is about right, which is why a wonderful business can be a poor investment and an ordinary one can be a good one. A valuation means more against its own history and against similar businesses than against the market.
High returns and somewhere to put them — a compounder needs both
Return on capital on one axis, room to reinvest on the other. The upper right is rare. The upper left is common, and fine, as long as the cash comes out.
8 · What is changing
Every measure above has a second version: which way it is moving.
Returns on capital rising or falling. Margins widening or compressing. Share count shrinking or creeping up. Debt building or being paid down. Stanley Druckenmiller spent a career on the observation that markets pay for the direction of change more than the level of it. A business going from poor to fair can be the better investment, because the price has usually already settled what excellent is worth.
9 · The same questions, turned on a fund
A fund is a basket of holdings, a cost, and a manager or a rule.
| Ask | Why it matters |
|---|---|
| What does it hold? | How far it differs from the index it is measured against |
| What does it cost? | The only figure known in advance, and it compounds against you |
| How often does it trade? | Turnover drives both cost and tax |
| Who or what decides? | A manager, a rule, or a committee, each with different failure modes |
| What happened in a bad stretch? | The only part of a record that tests anything |
A fund also has fundamentals of its own, aggregated from what it owns. Morningstar has spent forty years working out how to present them and how to describe a manager, and their research pages remain the best place to read a fund rather than anything we would build to replace them. What we look at there, and why:
| On the research page | What we take from it |
|---|---|
| Expense ratio | The cost, known in advance, before trading costs, which are separate and unstated |
| Turnover | How much changes in a year, and roughly how tax-friendly the fund is to hold |
| Portfolio holdings and top ten weight | A concentrated set of decisions, or a diversified average |
| Style box and sector weights | What it is actually exposed to, which often differs from its name |
| Portfolio P/E, P/B, and ROE | What the basket costs, and the quality of the businesses inside it |
| People and Process ratings | Morningstar’s own read on the manager and the discipline, which is the part hardest to see from numbers |
| Manager tenure and ownership | Does the record belong to the person running it now, and do they own the fund |
| Upside and downside capture | How the fund behaved when markets fell, which is the part of a record that tests anything |
Bond funds answer to a different set of numbers, and the ones that matter are mostly about what happens when rates move and when a borrower disappoints.
| On a bond fund | What we take from it |
|---|---|
| Duration | Roughly how much the price moves for a change in rates. The single most useful number on the page |
| Average maturity | How long until the bonds come due, which is related to duration but not the same thing |
| Credit quality breakdown | Who owes the money, and how much of the fund depends on borrowers who may not pay |
| Yield to maturity | What the portfolio is set to earn if the bonds are held and paid. More honest than the distribution yield |
| Distribution yield | What is being paid out now, which can include return of capital and can flatter a fund |
| Sector mix | Treasuries, corporates, mortgages, municipals, each behaving differently in a stress |
| Expense ratio | Costs matter more in bonds than in stocks, because the return is smaller to begin with |
Peter Lynch told individuals to own what they could follow. The fund version is the same test: if you cannot say what it holds and what it costs, you are holding somebody else’s opinion.
All of it is a record of the past, written under accounting rules.
A spotless record can belong to a business that has not yet met its competitor. And the rules themselves leave room: depreciation schedules, what counts as maintenance, how acquisitions are carried. Two companies acting in good faith can present the same business differently, and one acting in bad faith can present it however it likes for a while. Philip Fisher went and asked instead, talking to customers, suppliers, and competitors about what a filing would never contain. Nick Sleep looked for companies handing their scale advantages back to customers rather than keeping them as margin, which makes this year’s numbers worse and the position ten years out much better. He held one of those businesses for years on that reading while its reported profits stayed thin. The numbers told him what was being spent. They could not tell him what it was buying.
Where this lands
This is the Graham and Dodd tradition, taught at Columbia since 1928 and carried since by people who agree on almost nothing else. Its claims are few. A share is a piece of a business, so it has a value that can be estimated from what the business earns and owns, separate from what it trades for. Price and value come apart, sometimes for years. Estimating value takes a margin of safety, because the estimate will be wrong. And the market is there to serve you rather than instruct you, which means the right response to a price is usually nothing. Everything above is the arithmetic underneath them.
- The price is an assumption of all future expectations priced in to today. The opportunity is in the distance between what actually happens and what is currently priced in.
- The income statement records profit as it is earned. The cash flow statement records money as it moves. A business can report a profit it has not collected, and collect cash it has not yet earned.
- Return on invested capital is what the business earns on the money already in it. Return on incremental capital is what it earns on the next dollar, and that is the one that prices growth.
- Consistent, linear growth and earnings are usually worth more than lumpiness and cyclicality, though both can be accounted for.
- Return on capital is margin multiplied by turnover.
- A good acquirer’s return holds up across time and business cycles.
- Goodwill is the premium paid above the value of what was bought. Write-downs are the late admission that the price was wrong.
- Earnings per share is what an owner receives. Buybacks below what a business is worth transfer value to the holders who stay; above it, they take value away.
- A valuation means more against its own history and against similar businesses than against the market.
- Markets pay for the direction of change more than the level of it.
- A fund has fundamentals too: its cost, its turnover, what it holds, and the quality and price of the businesses inside it.
- Culture, customer treatment, and what a dollar of spending is actually buying may never appear directly in the numbers. But they often do, and should be understood.
Reading what stands behind a price.
Studying businesses and funds this way, and holding the ones that earn it, is the daily work of this practice.
How we work →Educational content only. This article is for informational and educational purposes and does not constitute personalized investment, tax, or legal advice, and does not create an advisory relationship. The measures described are analytical frameworks, not a method for selecting securities, and no business, industry, fund, or security mentioned is a recommendation. Financial statements are prepared under accounting rules that involve judgment and can be misstated. Past financial results do not predict future results, and no return, outcome, or performance is shown or implied anywhere in this article.
Benjamin Graham, David Dodd, Warren Buffett, Charlie Munger, Michael Mauboussin, Alfred Rappaport, Joel Greenblatt, Peter Lynch, Philip Fisher, Howard Marks, Stanley Druckenmiller, and Nick Sleep are referenced for their publicly documented approaches and writing, paraphrased for education. Nothing here is a quotation, and none of them has any connection to, or endorses, TenBroeck Wealth Management. All investing involves risk, including possible loss of principal. The firm and its related persons may or may not hold any security, fund, or asset class mentioned, and any such position may change at any time.
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Written by Schad TenBroeck, CFP®, Principal. CFP Board owns the marks CFP® and CERTIFIED FINANCIAL PLANNER® in the United States.