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Analyzing a company’s fundamentals is a lot easier (and faster) when you have a checklist to work off.

In this chapter, you get that checklist in what the author calls the Six Step Dance.

These six steps will help you determine whether a stock's shares are over or undervalued.

You don’t need to go through all six steps for every company you want to analyze. As soon as the company fails one step, you can consider it a dud and move onto the next one.

However, don’t skip steps. A company should pass all six to be considered a good trade.

A company in a strong industry is more likely to be profitable, so it makes sense to take a little time to understand the industry.

Follow these four steps:

1. Learn how the company makes profits. Does it sell a commodity or service?

2. Determine whether the company is in a growth- or value-oriented industry.

3. Find out what the rate of earnings growth is for the industry in the upcoming three to five years.

4. Determine what stage the economic cycle is in as this affects industry performance.

The first step in the Six-Step Dance is to figure out if the company is growth- or value-oriented.

Here are the growth industries:

• Consumer cyclical (businesses that cater to the general consumer such as retailers, homebuilders, cable companies, auto manufacturers, etc.)
• Healthcare (pharmaceutical, biotech, HMOs, etc.)
• Information technology (software development, semiconductors, etc.)
• Telecommunications (cellular service providers, cell phone manufacturers, etc.)

Here are the value industries

• Consumer staples (grocery stores, food and beverage production, cosmetics, etc.)
• Energy (drilling companies, equipment manufacturers, integrated energy, etc.)
• Financials (banking, REITs, insurance, investment firms, etc.)
• Capital goods (defense, railroads, farming and heavy equipment manufacturers, etc.)
• Basic materials (paper and steel manufacturers, chemical specialty companies, etc.)
• Utilities (electricity, gas, etc.)

Sectors perform differently depending on the economic cycle as shown here:

Always analyze companies in comparison to others in their own industry.

Comparing the growth rate of a tech company, for example, to that in the consumer staples industry isn’t a fair match.

When a company is financially stable it generates cash from operations which it uses to fuel growth.

It will have low (or zero) debt.

The current ratio measures if a company can comfortably meet its near-term financial obligations by comparing short-term assets to short-term debts.

It answers the question, “Will this company be okay (or thrive) over the next 12 months, or will it struggle to survive?”

Look for a current ratio of at least 1.5. If it is very high, e.g, 5, it doesn’t make much of a difference. But it should be at least 1.5.

The debt to equity ratio tells you how a company finances assets via equity and debt.

A higher debt to equity ratio means a company is highly leveraged. This is a bad sign.

Look for debt to equity below 30.

This ratio measures how well a company covers the interest payments on debts.

Look for an interest coverage ratio of at least 5.

Look at the company’s historical record to determine which way (or if) it is trending. Use the following steps:

Examine sales and earnings growth over the last several years and determine whether or not it is growing faster than its industry peers.

Also determine if that growth is accelerating or slowing down.

Look for companies with an earning growth rate of at least 25% in the previous two quarters when compared to year-ago periods.

Also ensure there is an annual earning growth rate of 25% over the last three years.

Next, you need to examine what a company is likely to earn in the future. After all, Wall Street values companies based on future projected income, not what happened in the past.

The best way to do this is by looking at analysts’ estimates. This is their job and they spend a lot of time doing it.

Also look at the earnings surprise history table, which compares a company’s actual reported earnings to the consensus from analyst estimates. You want to see if analysts are consistently under- or over-valuing the company’s sales and earnings.

Understanding the fundamentals of a company’s main competition will give you insight into if its shares are trading at a discount or a premium in comparison.

Look at how companies within the same industry differentiate from each other. Here are some strategies they may follow:

• Cost-leadership: The lowest-cost provider in the industry, e.g., Walmart
• Differentiator: A better product at a premium price, e.g., Tiffany and Co.
• Cost-focus: Lowest prices on a narrow part of the industry, e.g., manufacturing cheap memory for PCs
• Differentiator-focus: A superior product in a niche market, e.g., NVIDIA focusing on graphics cards for gamers.

This final step is the most important. It uses a relative valuation model to determine if a company’s shares are properly valued in comparison to its competitors.

First, gauge the shares' relative cheapness or expensiveness. Do this primarily with the price to earnings ratio (P/E ratio).

Calculate P/E by dividing the share price by the previous 12 months of earnings per share. The lower the number, the cheaper the stock.

Additionally, you must look at a couple of other metrics since the P/E ratio alone can be easily distorted.

• Price to cash flow divides the market cap of a company by its trailing 12 month cash flows. The lower the number, the cheaper the stock.
• Price/earnings to growth ratio (PEG) is calculated by dividing a company’s P/E by its annual EPS growth rate. The lower the number, the cheaper the stock.

The next step is to figure out if this share-price difference is justified.

A company should trade at a price similar to its P/E growth rate. For example, if a company is growing at 10%, It should trade at 10 times its earnings.

Determine a company’s growth rate by looking at expected earnings growth rates.

Always compare a company to its industry peers. You want to go long on those that are trading on a discount in comparison.

If you ever come across figures that seem a bit off, skip that company. For example, if a company’s shares show higher margins but lower growth rates in comparison to its peers.

If you are not into doing fundamental analysis, then at the very least, check out the company’s earnings per share (EPS) rank.

The EPS rank compares a company’s earnings to the rest of the market.

There are two places you can find this ranking. Investors Business Daily and HGS Investor. The higher a stock’s ranking (from 1 to 99) the better.

You want a company to have an EPS of at least 80.

The ranking isn’t as accurate as the Six Step Dance, but it provides a fast way to get a good idea of a company’s financial health.

Read the next chapter here.

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