Part 4: Is BUD a Buy?

Editor's Note: This is the fourth installment in a five-part series on the Basics of Fundamental Analysis by Contributing Editor Andrew Greta. The first part introduced fundamental analysis. The second part discussed dissecting the balance sheet, using Anheuser-Busch (BUD) as an example. The third installment reviewed BUD's income statement. Today, Greta decides, based on the prior two days of analysis, whether BUD is a buy. He welcomes your questions and comments, which he'll be pulling together into a Q&A for the final installment.

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We've been through the mechanics of fundamental analysis. We've shown you the nuts and bolts, given you some basic tools and presented a blueprint for analyzing stocks. Up until this point, our discussion has been largely based on the known quantities of past performance. Now it's time to put it all together, think about what our discoveries mean for the firm going forward and decide whether to bite the bullet and buy.

A Word on Stock Values

When you invest in a company, you're not really buying the actual assets or even the current year income. You're buying the productive power of those assets, managed wisely, to produce earnings far into the future. This future stream of predicted earnings is what really gives a stock its value, which is why you hear so much about analysts' earnings estimates and "whisper" numbers -- the unofficial estimates that industry and Wall Street insiders buzz about.

From a textbook standpoint, the value of a stock is the entire stream of predicted cash flows generated by the firm, discounted at a given percentage to yield a present value of the company at today's dollars. Think of the process like your home mortgage in reverse. Instead of hitting up your loan officer for, say, $200,000 at 8% and asking what the payment would be, you're offering your banker $1,467 dollars a month for 30 years and asking what he'll pay for it now.

The big difference is that with a bank loan, the payments are extremely predictable and the interest rate is fixed. With stock valuation, both the future earnings and discount rate are pretty much unknown, so you get wide variations in predicted values. In addition, small changes in today's earnings have a ripple effect on future forecasts, resulting in big price swings when companies report above or below analysts' consensus expectations.

As a result, stocks that fare well under fundamental analysis and a "value" appraisal tend to be companies with a relatively stable earnings growth history. That's why you see value investors focusing predominately on blue-chips instead of tech start-ups. The feeling is that if you can buy a solid stream of earnings selling at a cheap price in the market, you'll make out like a bandit in the long run.

The Bottom Line on BUD

From our two-day analysis, it appears that BUD is a financially strong company that's fairly valued in the marketplace. Turning to the balance sheet, the overall financial structure of the company seems sound. It has large physical assets, but these are financed appropriately with long-term debt and common stock.

The current ratio (or liquidity cushion) is pretty low at 1.06, suggesting that rapid expansion for BUD is just not in the cards. The number is stable over time, though, so there are no major negatives -- there's just a lack of stunning positives.

The price-to-book ratio for BUD is more than twice as high as the industry average, indicating that management has done a good job increasing shareholder value throughout the years. It also means that it's not much of a bargain in the marketplace (some might even call it overvalued from this angle), so don't look for a price-popping buyout anytime soon.

Finally, the debt-to-equity ratio is hovering right around 1.0. This is pretty much the threshold level for strict value disciples, but more liberal analysts would call this a decent number, and it shows a prudent balance of stock and bond financing for the company.

Switching over to the income statement, BUD has a solid earnings picture, albeit one that's slowing a bit over time. Again, not exactly a sprinting hare, more like a steady-going tortoise that makes slow, constant progress year after year.

Profit margins, on the other hand, are high and slowly growing, confirming BUD's dominant market position, brand loyalty and commitment to cost reductions.

In addition, BUD has its debt obligations covered with income eight times over. No real fear of a bankruptcy or bond default here.

Finally, the P/E is about average for the industry. Strict value players would probably want to see that drop down below the market average before stepping up to the plate, but it's still not what I'd call extremely extended.

So what have you got? No clear-cut, black-and-white answers to our questions about the firm's outlook. And that's not unusual. Rarely will a stock diagnosis show a company hitting on all eight cylinders. That's where the good investors make the leap from science to art. They balance multiple variables in their own minds to generate a picture of the future. If it were easy, there'd be no advantage in the market for folks who do their homework.

In this case, what I'd do next is read up on the company and its market and think about the firm from a less quantitative approach. BUD's main product, beer, is simple, relatively easy to produce and seems to enjoy nearly recession-proof sales. Major risks in terms of commodity price increases, higher excise taxes or draconian federal legislation seem remote at best. The tradeoff for BUD's predictability, however, is a lack of explosive growth prospects in the domestic beer market, although international expansion is always a possibility.

Pulling it all together, my impression is that BUD will be a modest but relatively safe performer in the years to come at its current price. That's not to say it's a bad stock -- you just have to get it at a price that undervalues its productive capability. As such, BUD is definitely a stock to watch if the broader market drags it down in a selloff.

If, for example, you see the P/E dip well below its historical average and you don't think the earnings outlook has changed, that could be your buy signal. Because of BUD's defensive nature, any price hit will probably be based more on general market anxiety than on the fundamentals of the company, which should remain pretty solid going forward. Let's face it, even in the midst of Armageddon, folks still gotta have their cold frosty. For me to think of BUD as a major growth prospect, however, it would need to show some new innovations in either products or markets where it expects to make big sales gains.

This series presented a mere taste of the complex world of fundamental analysis. Now it's time for you to pick a stock and give it all a try. I'm anxious to hear any comments or questions, which I'll try to answer in the Q&A I've been preparing for this series. I've already received many terrific questions. Please keep them coming.

For Further Reading:

The selection of reference materials geared toward the educated investor out there is pretty slim from what I've seen. Here are a few titles that have crossed my desk over the years and may prove helpful in your own quest to understand corporate financials. Feel free to email me your personal favorites so we can include them in subsequent pieces.

Graham & Dodd's Security Analysis

This is one dry tome, but it's considered the fundamentalist's bible. Parts 2 and 4 -- on statement analysis and stock valuation, respectively -- seem to be the most valuable sections for the individual investor. Numerous ratios are printed inside the front and back covers of the latest edition for easy reference.

How to Profit from Reading Annual Reports by Richard B. Loth

This isn't particularly well written or organized, but it's one of the few books I could find on the subject geared toward the layman.

Financial Accounting: An Introduction to Concepts, Methods and Uses by Clyde P. Stickney and Roman L. Weil

This one's my old college managerial accounting text. It's got an entire chapter on financial statement analysis, including a section on useful ratios and their limitations. I'm not sure I'd spend the $96 again for a new one, but if you've got one serving as a doorstop, dust it off for review.

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