Every consumer is looking for a great deal. Whether that is on a new car or a new stock in their portfolio, everyone wants to feel like they have beaten the market. In the stock market world, this is called value investing.
Value investing involves the art of purchasing stocks that are trading for a discount relative to their actual value. Otherwise known as the stock's intrinsic value.
Investors can calculate the intrinsic value of a stock using a variety of mathematical equations and techniques.
Occasionally, you may find that there are stocks in the market that seem to be sold at a discount to their true value. For example, a value investor may aim to purchase shares of a company at $18 because he or she thinks its true intrinsic value is $25 per share.
Although it may seem like an easy thing, in reality, it is a difficult feat. Finding undervalued stocks is next to impossible because of what is termed the efficient market hypothesis. This belief states that the price of an asset already reflects all available information. The only way to move the value of a stock is by introducing new information.
After all, if a company becomes apparently undervalued, then everyone would be speeding to buy it, causing the price to rise. This would inherently mean that the company is no longer undervalued.
By far, the best book on value investing is The Intelligent Investor by Benjamin Graham. This is the very first book you should read as you enter the realm of investing. We will reference some of his ideas in this article.
As one of the techniques used in equity or stock valuation, fundamental analysis is a method that measures the intrinsic value, or true value, of a stock by looking at financial and economic factors.
In performing fundamental analyses, stock analysts study any factor that can affect the value of a security. These range from macroeconomic factors like the economy and industry conditions to other factors that are more microeconomic including the effectiveness of a company’s management.
Fundamental analyses aim to get a number that a value investor can use to compare with the current price of a stock or security to determine whether the stock is overvalued or undervalued.
Contrary to fundamental analysis, technical analysis involves forecasting the direction the prices of a stock are taking through analyzing the historical market data like volume and price.
You can think of it this way: fundamental analysis shows you the health of the company and technical analysis shows you the personality of the stock. For this article, we will focus purely on fundamental analysis.
For stocks, fundamental analysis utilizes metrics such as earnings, revenue, future growth, profit margins, return on equity, and other data to help determine the underlying value of a company as well as the company’s potential for future growth.
You can find this data in the financial statements of the company. Fundamental analysis, though mostly used for stocks, can also be useful in evaluating other securities like bonds and derivatives.
Investors can use equations to determine a company's intrinsic value on a per-share basis. There are many ways for an investor to compute a stock's value. These stock valuation models include the model of discounted cash flows (DCF) or the dividend discount model (DDM).
With fundamental analysis, you may look at the big picture (what's going on in the economy) as well as the small picture (what's going on within this company).
One of the platforms that offers both fundamental and technical analysis tools and research is Stock Rover. The Stock Rover platform can help you determine a company's valuation based on either fundamental or technical data.
Check out our full review of Stock Rover if you are interested in an investment research and portfolio construction platform.
When conducting fundamental analysis, investors are trying to come up with a model that helps determine the projected value of a company. The calculation is based on the data available to the public.
The price that investors get is only an estimate that revolves around facts and opinions of the analysis. This estimated price may sometimes be referred to as the intrinsic value of the company.
For example, an analyst may calculate the value of a stock as much higher than the current market price of the stock. This analyst can then publish a buy or what is known as an overweight rating for that stock.
This would mean that people may want to purchase the stock if they trust the analyst.
On the other hand, an analyst may calculate a lower intrinsic value than the current market price of the stock. They may then recommend a sell or what is known as an underweight rating.
The market pays a lot of attention to these analyst recommendations. Often, when an analyst makes a recommendation, the stock rises or falls based on his or her recommendation.
So, should you listen to these analysts? Maybe. But it is always best to do your own research and formulate your own opinions. Warren Buffett said it best when he said stock analysts are out there to make fortune tellers look good!
Quantitative fundamentals, an integral component of fundamental analysis, involve hard numbers. These are the quantifiable or measurable factors and characteristics of a business.
Quantitative data are items in a company's financial statements such as the balance sheet, income statement, or statement of cash flows.
Investors who use fundamental analysis believe a stock price reflects the per-share value of all future cash flows of a company, discounted to the present value.
To compute the present value of future cash flows investors may use a DCF model to project out the company's earnings.
For example, an investor may use a discounted cash flow projection to find the current value of a stock. This is completed by using a variety of factors and assumptions such as earnings, earnings growth rates, market sensitivity, and interest rates to determine the intrinsic stock price.
The financial statements of a company provide a medium by which the company is able to disclose data and information regarding its financial performance.
Fundamental analysts use the quantitative information from a company’s financial statements to make their investment decisions.
A balance sheet records the assets, liabilities, and equity of a company at a particular point. The financial structure of a business balances in the following way:
Assets - Liabilities = Shareholder Equity
Let's start with assets. These are the resources that a business owns and controls. Assets include things like machinery, inventory, cash, and owned buildings. When you look at the equation, assets represent what the company owns.
Equity is the value left over after the company paid all its liabilities. For example, a company can take a loan to purchase machinery – this is a liability because it has to be paid. Equity also includes the earnings that the company retains, meaning the profits that the company made the preceding year.
The income statement is used to measure the profit or loss of a company over a given timeframe. An income statement shows data about the revenue and expenses that a business generates from its operations.
Investors can use the income statement and growth rates to project out a company's earnings over time. This is the objective of the traditional method of fundamental analysis.
The statement of cash flows represents information about the cash inflows as well as outflows over a given time.
The statement of cash flows focuses on three types of activities. These are cash from investing, cash from financing, and cash from operations.
Cash from investing (CFI) is the cash a business uses to invest in assets and the proceeds obtained from the sale of its equipment, long-term assets, or other businesses it owns.
Cash from financing (CFF) is the cash the company pays or receives from borrowing or issuing funds.
Operating cash flow (OCF) is the cash the business generates from its day-to-day operations.
Fundamental analysts look at the cash flow statement because it is difficult for an entity to manipulate or alter its cash situation.
While accountants can try to manipulate the earnings of a company, it is very difficult to fake the cash that’s in the bank. Because of this, some value investors will use the cash flow statement to measure how a company is performing conservatively.
As we have just learned the ins and outs of quantitative analysis, another important part of the equation is qualitative analysis. Qualitative fundamentals are usually less tangible and are difficult to measure.
These may include characteristics such as the management of a company, the quality of the key executives, patents, brand-name recognition, and proprietary technology.
In qualitative fundamentals, analysts look at factors such as the business model, competitive advantage, management, and corporate governance. The business model of a company can say something about its position in the market above and beyond what the financials say.
The long-term success of a company may be driven by its ability to ensure a competitive advantage and maintain it.
Think of companies like Microsoft, Coca-Cola, and Apple. These companies dominate the market because they have established a competitive advantage. They keep their competitors at bay, meaning they enjoy profit and growth.
Not to mention, these companies all have some of the strongest brands out there today. A strong brand has a lot of value!
Even a business with the best model may not survive if the leaders fail to execute the plan properly. Again, the policies a company puts in place may determine the health of the business environment.
In qualitative fundamentals, it is also crucial to consider outside factors. This includes the industry of the company, market share, customer base, competition, industry growth, and business cycles.
Understanding how the industry in which a company competes allows the investor to gain insights into the current and future financial health of the company.
One of the best places to start this analysis is by reading through quarterly earnings reports or the annual reports that most companies produce. This will give you an idea of the overall vision for the company and the future.
In most cases, many analysts consider both qualitative and quantitative analysis when conducting fundamental analysis.
Fundamental analysis is the root of most stock valuation techniques. By using a fundamental equation with real economic and financial data, investors can have a more systematic valuation approach.
Using qualitative fundamental information can also be an important aspect of valuing a company. Company characteristics such as the quality of management and industry environment should never be overlooked.
So, by focusing on the fundamentals of a business, value investors can calculate the intrinsic value of a stock. The goal here is to find opportunities to buy stocks at discounted prices. When the market later catches up, the investment will prove whether or not it was a success.
If you want to learn more about investing, check out our beginner's guide to investing in the stock market!