Fundamental analysis is a “bottom up” valuation technique used to determine the market value of a stock, common share or equity security.
All securities can be valued by calculating the present value of their future cash flows.
The information needed to value a company is clearly stated in its financial statements. The Balance Sheet totals up the value of the Total Assets of a company and equates this to the value of the Total Liabilities plus the “Owner’s Equity”. Some simple algebra establishes that, at any point in time, the value of the “Owners’ Equity” of a company equals the value of its Total Assets minus its Total Liabilities.
A Fundamental Analysis or “Bottom Up” financial analysis of a company is used to establish its actual or “Intrinsic Value”. When you divide this value by the number of common shares, you get the “Intrinsic Share Value” on a per share basis.
The concept of “Intrinsic Value” is the cornerstone of Fundamental Analysis.
Determining Stock Values
An investor should use fundamental analysis to determine if a stock is undervalued, overvalued, or trading at fair market value.
If the investor examines all the available information about a corporation’s future anticipated growth, sales figures, cost of operations and industry structure, that analysis will provide the intrinsic value of the stock.
To a fundamental analyst, the market price of a stock tends to move towards its intrinsic value. If the intrinsic value of a stock were above the current market price, the investor would purchase the stock. However, if the investor found, through analysis, that the intrinsic value of a stock was below the market price for the stock, the investor would sell the stock from their portfolio or take a short position in the stock.
Investment analysts are the ones typically charged with trying to determine the “intrinsic value” of a stock. They want to figure out what it is really worth to investors, because its historical cost seldom reflects its actual value or its market valuation.
There are several steps associated with fundamental analysis. These analysts must first examine the current and future overall health of the economy as a whole and then attempt to determine the level of interest rates. This may be done through interest rate forecasting. An understanding of the relevant industry sector, including the maturity of the industry and its cyclicality, as well as how it is affected by the economic cycle will be required.
Once these steps have been undertaken, then the individual firm must be analyzed. This is the major focus of the “bottom up” investment analysis. Rather than make investment decisions based on “top down” macroeconomic, social and political changes, the analysis concentrates on the company concerned. This analysis must include the factors that give the firm a competitive advantage in its sector (low cost producer, technological superiority, distribution channels, etc.). Additionally, factors such as management experience and competence, history of performance, accuracy of forecasting revenues and costs and growth potential, among others, should also be examined.
After doing the analysis above, the analyst develops her qualitative view of the firm’s position within its sector and within the economy as a whole. This is necessary in order to understand whether a quantitative analysis should be undertaken.
If the analyst is sufficiently impressed with the issuer in question, then he is ready to develop a financial model of this firm. The analyst will usually use a spreadsheet to analyze and model the financial statements.
Once the quantitative description of the company is complete, there are two relatively simple models that can be helpful for the investor willing to better understand the firm under scrutiny. The two most commonly used methods for determining the intrinsic value of a firm are the “Dividend Discount Model”, often called the Gordon Growth Model after the Canadian professor who developed it, and the Price/Earnings or PE model. If employed properly, both methods should produce similar intrinsic values.
Dividend Discount Model
When using the dividend discount model, the type of industry involved and the dividend policy of the industry is important in choosing which of the dividend discount models to employ. As mentioned earlier, the intrinsic value of a share is the future value of all dividend cash flows discounted at the appropriate discount factor. For those familiar with the calculation of yield in fixed income analysis, the concepts are similar.
For Constant Dividends:
P=Dt/ke where:
- P = intrinsic value
- Dt= expected dividend
- ke= appropriate discount factor for the investment
This method is useful for analyzing preferred shares where the dividend is fixed. However, the constant dividend model is limited in that it does not allow for future growth in the dividend payments for growth industries. As a result, the constant growth dividend model may be more useful.
For Constant Dividend Growth:
P=Dt/(ke-g) where:
- P = intrinsic value
- Dt = expected dividend
- ke = appropriate discount factor for the investment
- g = constant dividend growth rate
The constant dividend growth model is useful for mature industries where the dividend growth is likely to be steady. Most mature blue chip stocks may be analyzed quickly and easily with the constant dividend growth model. This model has its limitations when considering a firm that is in its growth phase and will move into a mature phase at some time in the future. A two-stage growth dividend model may be utilized in such situations. This model allows for adjustment to the assumptions of timing and magnitude of the growth of the firm.
For the Two Stage Growth Model:
If a company is growing quickly and looks like its growth will slow, the dividend growth model can be adapted to provide for two stages of different dividend growth. The formula is given below:
P=Σnt=1[D0(1+g1)t/(1+ke)t]+Σ∞t=n+1[Dn(1+g2)t-n/(1+ke)t]
where:
- P = intrinsic value
- D0= expected initial period dividend
- Dn= expected dividend during mature period
- ke = appropriate discount factor for the investment
- g1 = expected dividend growth rate for initial growth period
- g2 = expected dividend growth rate for mature period
The two-stage model allows for greater flexibility in the testing of scenarios for the investor looking at a firm in its infancy or in a new industry.
Price Earning Model
The Price Earnings model takes the earnings per share of a company and multiplies it by the Price Earnings Ratio. This model has the benefit of simplicity, in that it can be calculated quickly if one has the Earnings Per Share (EPS) and share price by simply dividing the share price by the EPS.
Companies can then be easily compared and estimates made for the target company on this basis. For example, if the best company in the industry had a PE multiple of 20 times and the worst a PE multiple of 10 times, then an average company in the industry might have a 15 times PE multiple. Taking the average company’s EPS, say $1.00 per share, and multiplying it by 15 would give an intrinsic value of $15.
Judging companies based on their intrinsic value is a useful way to get around a lot of the noise associated with macroeconomic or political factors and get to the core of a company’s real value, which provides an investor with clear information to make decisions about what any stock is worth.
