Value investing involves the art of purchasing stocks that are trading for a discount relative to their actual value, also known as their intrinsic value.
Investors can calculate the intrinsic value of a stock using a variety of different equations and techniques.
Occasionally, you may find that there are stocks in the market that are sold at a discount to their true value. For example, a value investor may aim at purchasing shares of a company at $18 because he thinks its true intrinsic value is $25 per share.
Although it may seem an easy thing, in practice, the concept is complicated. Finding undervalued stocks is a difficult task.
After all, if a company becomes apparently undervalued, then everyone would be speeding up to buy it, causing the price to rise, which would mean the company is no longer undervalued.
Stock valuation is one of the most crucial aspects of fundamental analysis. This method applies the art of detecting assets that are undervalued or mispriced.
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.
What Is Fundamental Analysis?
Being 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.
Analysts study any factor that can affect the value of security from macroeconomic factors like the economy of the state and industry conditions to other things like microeconomic factors, including the effectiveness of a company’s management.
The aim is to get a number that a value investor or fundamental analyst 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.
Understanding 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, it 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 investors to compute a stock's value. These stock valuation models include the discounted cash flows model (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).
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When conducting fundamental analysis, you 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 value they get is only an estimate that revolves around facts and opinions of the analysis. They find what the share price of the company should be worth in relation to the current market price.
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 to be quite higher than the current market price of the stock. They 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 believe the analyst. The estimated intrinsic value or true value of the stock may be higher than the prevailing price of the stock in the market.
The investors who follow the analysis may use this recommendation to decide whether they should invest or not.
On the other hand, an analyst may calculate a reduced 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 times, when an analyst makes a recommendation, the stock rises or falls based on what the recommendation is.
So, should you listen to these analysts? Probably not. It is 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!
With quantitative fundamentals, they involve hard numbers – quantifiable or measurable factors and characteristics of a business.
Quantitative data is things like financial statements and other measurable data.
Investors who use fundamental analysis believe a stock price reflects the per-share value of all future cashflows of a company discounted to the present value.
To compute the present value of future cashflows investors may use a model to project out the company's earnings.
For example, an investor may use a discounted cashflow projection to find the current value of a stock. Using a variety of factors such as earnings, earnings growth rates, market sensitivity, and interest rates to determine the intrinsic stock price.
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. The statements include a balance sheet, an income statement and cash flow statements.
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 = Shareholders Equity
When it comes to assets, they are the resources a business owns and controls within a given time.
Assets include things like machinery, inventory, cash and buildings. When you look at the equation, assets represent what the company owns.
Equity is the value of money left over after the company pays for all 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 and 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 within a given time.
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.
Statement Of Cashflows
When it comes to the statement of cash flows, it represents information about the cash inflows as well as outflows over a given time.
The cash flows focus on activities such as cash from investing (CFI) – which 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.
Also, cash flows focus on cash from financing (CFF) – which is the cash the company pays or receives from borrowing or issuing of funds.
Also, cash flows focus on operating cash flow (OCF) – which 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. So, some value investors will use the cash flow statement to measure how a company is performing conservatively.
With qualitative fundamentals, they are usually less tangible and 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 a factors such as the business model, the competitive advantage, the management and corporate governance. The business model of a company can say something about its position in the market, hence its stock value.
Also, 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 and Coca-Cola. These companies dominate the market because they have established a competitive advantage. This way, they keep their competitors at bay, meaning they enjoy profit and growth.
Look at a company like Apple; they have intuitive management that is always ahead in technology. That’s why they have products that even if they sell higher than their competitors, people still love them and buy them.
Not to mention, Apple and Coca Cola also have the strongest brands of any companies out there today. That 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 of the company works 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.
Understanding Intrinsic Value
Fundamental analysts often assume that the current stock price in the market does not reflect the true value of the company.
These analysts assume that the fundamental data will reflect the true value of the company’s stock. Analysts try to project out what a company is worth using equations based on current financial information. So, analysts refer to this inherent true value as the company’s intrinsic value.
Think of it this way: a company’s stock is trading at $30.
After comprehensive research about the company, a fundamental analyst computes that the company’s stock ought to be $20.
In this case, the stock is trading well above the intrinsic value. The analyst will not want to buy this company because he believes its overvalued. The market is trading this stock at a premium to what the analyst believes is its intrinsic value.
Fundamental analysts assume that the market price will be correct over “the long run.”
Usually, in the long-run, investors believe that the market will eventually reflect the fundamentals.
However, the problem is, you never know when that long run will come to be. It can take days, months, years, or even decades before the stock market reflects the fundamentals as derived by the analysts.
Even if a stock is undervalued or overvalued right now, that does not mean the true or intrinsic value will be reflected anytime soon.
Fundamental analysis is the root of most stock valuation techniques. There are thousands of stock valuation formulas. But by using a fundamental equation with real economic and financial data it can be a more systematic valuation method. Especially when compared to other valuation methods.
But also using qualitative fundamental information can be an important aspect of valuing a company. Company characteristics such as 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!