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Fundamental analysis of stocks is to value investors as water is to fish.
Fundamental analysis refers to the set of techniques investors use to determine a company’s intrinsic value. As a value investor, one uses fundamental analysis to identify companies worth placing a stake in.
This type of assessment tries to answer a few questions. Namely:
Does this company have profits? Can it continue making money in the future? Will it be able to hold onto its position in the market? How much debt does this company have and is it serviceable?
Each one of these questions can be a giant rabbit hole you can fall down but at the end of the day the question one is really trying to answer boils down to this:
What is this company really worth?
The Goal of Fundamental Analysis: Finding the Intrinsic Value of the Stock
Intrinsic value, or actual worth of a firm, is the Holy Grail to value investors. Value investors are always looking for stocks that are trading at a discount to intrinsic value. The driving belief here is that the stock price given by the market does not always accurately reflect the true value of a stock. Because of informational lags, or irrational exuberance on the part of speculative investors, a company’s stock price can become detached from its true value. Stock analysis based on the fundamentals of the company aims to find the variance between the value and the price.
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The Toolkit
There are numerous ways to go about calculating intrinsic value –each method attempting to put a price tag on a specific business.
Balance Sheet Analysis
One straightforward way to do this is to dig into the financial statements of a company and assess its finances. This is also known as balance sheet review, and a simple strategy is to examine financial statements to calculate the Net Current Asset Value (NCAV) of a company.
Famous value investor Ben Graham actually created Net Current Asset Value as a way of understanding intrinsic value and whether or not a company was trading at a fair price. Net Current Asset value is simply the difference between current assets and liabilities and gives an investor a sense of what a company is worth if it had to be liquidated.
Graham recommended calculating NCAV per share, and buying businesses if they were trading at prices lower than two-thirds of NCAV per share.
Comparable Company Analysis
Comparable company analysis or ratio analysis is another method of estimating intrinsic value, and if an exercise where the value of a company is assessed in comparison to the other companies in its industry or sector. Many Wall Street analyst use comparable analysis, judging a company within a peer group across different multiples or metrics to get a sense of whether or not a company is over or undervalued.
With this approach it’s important to understand the multiples one uses, whether evaluating on price-to-book, earnings per share, or EBITDA (earnings before interest, taxes, depreciation and amortization).
You might use multiples such as the PE ratio and Price-to-book ratio to determine is a company is cheap (relative to peers) and then screen for high performers. The types of multiples that are useful in this endeavor are ones that measure long-term profitability and high return on equity. The idea is to find the best companies for the cheapest prices, with the ability to sustain themselves in the future.
Discounted Cash Flow
Another tool that investors use to calculate intrinsic value is the discounted cash flow model. The premise of this method of valuation is that it sets the intrinsic value of a business as the sum of all of its future cash flows, discounted to the present-day.
Let’s examine that. At any given moment in time, if you were stop the clock and freeze the world, a business would be worth whatever money it could get from selling its existing inventory, equipment, buildings and other property, plus whatever cash it has in the bank or in investments.
When you start time back up, things get more complicated. Imagine you were going to buy a company outright just as it landed a billion dollar contract. Put yourself in the seller’s shoes. It’s easy to see that the value of the business has some connection to the huge contract that was just won. The promise of cash in the future affects the price you pay today.
There are a few variations to discounted cash flow analysis (DCF) – including the dividend discount model. The strength of DCF is that it is infinitely customizable, the point is to have a model that one believes accurately reflects the reality of the market.
So to understand intrinsic value using DCF, one must estimate the total value of a business’ future cash flows. Typically this involves forecasting cash flow for a number of years as well as estimating the long-term cash flow of a business past that initial time-frame until the end of time. That long-term estimate is known as the terminal value.
Once you’ve come up that, it’s time to adjust back to the present day by applying a discount rate. There are a number of different rates you can use. Warren Buffett often states that he simply uses the 30-year Treasury rate but another approach is to use the weighted average cost of capital (WACC), a measure that reflects the cost of raising funds.
The present value that one calculates using DCF gives us a figure for the intrinsic value of a company. You can then calculate a per share figure to evaluate whether or not the company is worth buying.
Science Meets Art in Fundamental Analysis
Fundamental analysis is both an art and a science. It relies on the use of systematic and methodical approaches to estimating the true value of a business. We want this because there needs to be a way to apply a logical framework to investing decisions, but we also have to realize its limitations. For instance, discounted cash flow analysis is a powerful tool but can have drawbacks. Sometimes changing one figure in your DCF model can drastically change your intrinsic value calculations – leaving you paralyzed when it comes time to make a buying or selling decision. Knowing which tool to use, when to use it and how to extract maximum value is where the art in fundamental analysis comes in.
Sources:
Staff, Investopedia. “Discounted Cash Flow (DCF)” Investopedia. N.p., 29 Sept 2015. Web. 30 May 2017
Damodaran, Aswath. “Intrinsic Valuation in a Relative Valuation World…” http://people.stern.nyu.edu/adamodar/pdfiles/country/relvalFMA.pdf. Web.
Jiva Kalan is a writer whose work has been featured on DailyFinance, the Wall Street Survivor, Plousio and Financial Choice.