The Return of Graham and Dodd

Who would've ever thought that Graham and Dodd, the progenitors of fundamental stock analysis, would be in vogue again.

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But like your favorite pair of jeans, they should've never gone out of style. We might not be in this market mess if we stuck to their basic theories.

So, lately everyone -- including yours truly -- has been lobbying for the return to fundamental analysis when evaluating stocks. But what are these fundamentals? What should you look for? Where do you begin?

There's no reason why you shouldn't be doing financial analysis on your stock picks. You would never buy a car or a refrigerator without reading Consumer Reports and digging up all the latest research, so it only makes sense that you do the same extensive investigations on your stock portfolio.

Fundamental analysis means you actually have to read the financial statements. It's a way to value a security by examining the company's financial health and operations. And while this may sound a bit trite, "you do have an edge if you understand what's going on in the financial statements," says Bob Olstein, who runs the (OFALX)Olstein Financial Alert fund (which, by the way, is up about 5.6% for the year vs. the S&P 500, which is down over 12%).

So pull up your company's most recent 10K -- the official document that companies must file with the Securities and Exchange Commission 90 days after the close of their fiscal year -- off of Edgar Online or the annual report off your company's Web site. Either will have the financial statements you need to get started.

Read the MD&A

First, understand what business or businesses the company is in, says Robert Herz, chairman of the SEC regulations committee and a PricewaterhouseCoopers partner. Understand its product or services. You may be surprised to find that your company toils in nonrelated sectors. For instance, did you know that not only does GE (GE) bring good things to life in the kitchen, but it also produces nuclear power support services and military aircraft jet engines? If you own or are considering buying the stock you should know this because you're getting exposure to many different sectors.

That's why reading "Management's Discussion & Analysis" should be your first step. It's the big narrative that comes right before the numbers section of the financial statements in the 10K or annual report. It should give you a good overview of what the company does and what's going on in the industry. It also is a good introduction to the company's operating results and current outlook.

What's the Company's Growth Rate?

Then flip to the income statement and look at the total revenue number. (Note: revenue and sales are used interchangeably.)

Instead of combing through the numbers in the report, you can use a good financial analysis site like Market Guide (my favorite). All the numbers you need to do a quick fundamental analysis are there.

You want to see a positive total revenue number that's been increasing over time. That means sales are going up.

How much is revenue increasing or decreasing? Figure out its growth rate. Calculate the percent difference between current year and prior years. Do it for the previous periods as well, so you can be sure that growth is increasing with time.

Market Guide calculates this percentage for you. You can also see the company's growth rate over the past five years. Be sure to compare these numbers with those of industry peers.

Can It Pay the Day-to-Day Bills?

The next number to analyze on the income statement is operating income. This number tells you if the company is making enough to run its day-to-day business. It's what's left after all its operating bills -- like marketing, payroll and utilities -- are paid.

So ideally, you're looking for a positive number here. And again, you'd like to see it increasing over time.

Why aren't we looking at net income? Because net income has other stuff in it -- like interest and taxes -- that have nothing to do with whether the company can run its day-to-day business. In addition, investment income is lumped into net income. That's the extra money the company makes from its investments in outside companies. But that's not money it made selling its product or services. So unless you can tear it apart, stick with operating income.

It's Cliche, but Cash Will Always Be King

Do you balance your checkbook? You should (or you should have a software program do it for you). Well, you're not the only one with this tedious task. Companies have to do it, too. The cash flow statement is their checkbook, so flip or click to it now. It measures cash inflows and outflows over a given period and is one of the most important indicators of a company's financial health. It tells you where the company is getting its money from and where it's spending it.

Look at "total cash from operating activities." Cash flow from operations tells you about the cash flow surrounding the sale of a product or service. If it's negative, that means the company doesn't have enough cash coming in to run its day-to-day business. That's a problem.

Is your company a newbie? Then you might want to check out "net cash from financing." This is where all the venture capital money is reported. If that number is positive, it means there are investors out there that have helped to finance the company. You can take some comfort in that if your young company has negative cash from operations.

Finally, look at the total net change in cash. Overall, you'd like to see a positive number. "In tough times, cash is what you need to survive," says Ashok Ahuja of Icor, a Westport, Conn., firm that operates a technology hedge fund.

You Have to Start Somewhere

There are many different numbers to investigate when analyzing financial statements, but looking at these few should give you a basic understanding of what your company does and where it stands financially.

So dust off your security analysis books -- and this time, don't put them away.

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