The financial statement as an analysis framework 4 comments

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One is buffetted by so much breaking news every day that if he does not develop a disciplined framework for analysing the impact of those news on the stock market and the sectors/companies within, he will quickly be overwhelmed. Such a framework should be standardised, versatile and intuitive.

The simplest method to parse the qualitative, or even quantitative, effects of new developments, such as the recent sub-prime crisis, is none other than via utilisation of the financial statement as a mental framework. Over the years, I have come to rely on it as the quickest and most intuitive way of thinking about stock price impact.

If one considers fundamentals as being the main rational driver of stock prices over the medium-term, and earnings being a chief source of these fundamentals, then the below diagram, split into two parts, should make sense immediately.











The first part (1) is basically a compression of the P&L (profit & loss) statement to its key components Revenue and Costs. A consideration of the effect of a new development on these two components would yield an idea of its earnings impact.

The second part (2) illustrates how earnings impact translates to share price impact. One has to recognise that Valuation multiple (eg. PE ratio) is what bridges the two. While the valuation provides a potential "price target" so to speak, it is Liquidity, on the other hand, which greases the wheels and determines whether the "potential" can be fulfilled. And so the "fair" market price is determined.

I believe that this is a more comprehensive way of thinking about fundamentals rather than simply earnings as a catch-all, which is what most people often focus on. Consider, for example, the recent sub-prime crisis and its implications on fair market prices.

Walking through the framework, it is possible that for many companies, especially export-oriented ones, revenue might be affected as a result of poorer consumer sentiment contagion from the US across the world (incidentally, I'd discussed this in an article last December "US consumption slowdown"). Cost impact may not be so significant, unless the company has heavy financing costs which might escalate as banks demand higher lending yields (might be offset by lower raw material prices as global demand falls).

The more immediate share price impact, however, relates to the twin factors of valuation and liquidity in the second part of the framework. Fair value multiples tend to contract in the face of uncertainty, which can be seen in the lower PE targets set by brokers nowadays (take a look at their reports the last two weeks). Liquidity was the greatest factor; in fact the credit scare two weeks ago, when no banks wanted to lend to one another, was a reason to sell in itself, because of the terrible implications it portended for global finance and liquidity should the situation persist. Thankfully, the clouds appear to have cleared.

What the framework brings out, therefore, is a methodical approach to look at earnings components (revenues, costs) and also how it bridges across to share prices (via valuation and availability of liquidity). By careful consideration of its implications, one can sometimes also get a better idea of what sectors to buy and which to avoid. For example, in the sub-prime example, the clear sectors to avoid based on revenue consideration would be exporters such as electronics companies, which depend on the US consumer for growth. Also, those companies which supply to US homeowners should also be given a wide berth on basis of retarded future growth, for example furniture companies. Some risk-averse investors might even choose to avoid stocks as an asset class altogether, given that global liquidity might have tightened for the medium-term at least.