Fundamental Analysis

Fundamental Analysis - Kinderdijk - Netherlands
Fundamental Analysis

Within the context of the fundamental analysis, the price of a stock is determined by taking into consideration two fundamental elements of valuation: expected return and risk. To form return and risk expectations, a thorough analysis should be carried out at
  1. the economy level, 
  2. the industry level, and 
  3. the company level.

At the end of the analysis, the intrinsic value of a stock is determined and compared with the current market price. The underlying assumption is that the market price approaches the intrinsic value in the future. The comparison of the intrinsic value and the market price is vitally important in deciding whether the stock is mispriced.

Finding out that the stock is overvalued (requires a sell decision) or undervalued (requires a buy decision) is in itself not sufficient to make such a trading profitable. The profit is realized only if that particular stock is found and valued in the same way by most of the other investors who will make similar buy/sell decisions. The overall effect of these similar decisions is to change the demand for the stock that, in turn, changes its market price in the future.

The major steps in the fundamental analysis are as follows:
  1. Transformation of the results obtained from the analysis of the selected macroeconomic variables such as the money supply, government budget deficit (surplus), the economy’s potential output capacity, and other national/ international events into tools for prediction of the likely changes in the future performance of the economy.
  2. Determination of the sensitivity of each industry to the predicted changes in the economic activity. It should be noted that the usefulness of the industry analysis in investment decisions depends on the quality and amount of information on industries, the length of time devoted to the analysis, and skill/expertise in
    • understanding and interpreting the information contained in the financial, economic, and on all other types of relevant data; 
    • building a model to value industries, interpreting the results of the evaluation; and 
    • using them in investment decisions.
  3. Evaluation of the behavior of each company in each of the selected industries and calculation of the intrinsic value of each company’s stock.

It should be noted that anticipated changes in the economy, or in specific terms, an anticipated expansion (or contradiction) in economic activities would differently affect the growth rates of industries. For example, not all companies in an expanding (or contracting) industry are expected to grow (contract) evenly.

There will be differences among the growth rates of companies operating in an industry. Therefore, the primary aim of the company analysis is to select companies whose stocks appear to be overvalued or undervalued. The steps of the company analysis are stated as follows:
  1. To analyze and assess the qualitative characteristics of companies to gain an insight into current and future earnings strengths. Some major qualitative characteristics are (a) quality of management: in the determination of the future value of the company, the quality of decisions made at the present by the management plays a crucial role; (b) competitive position: company’s ability to compete successfully with its competitors is determined collectively by company size, product diversification, research and development outlay, the nature of protection on the new products, and know-how; and (c) quality of earnings: quality of earnings is determined based on the company’s activities that generate them. In other words, earnings generated by the extraordinary activities are not sustainable and not contributing to the quality of earnings, whereas earnings generated by ordinary activities are continuous and increase the quality of earnings.
  2. To analyze and assess the financial performance of companies in order to provide or support the conclusion reached by analyzing qualitative variables. Financial statements are the primary source of information that an individual investor relies on to support the judgment on the company after analyzing its qualitative factors.
  3. To determine the intrinsic value of the stocks of the companies under consideration. Conventional valuation techniques are employed to calculate the intrinsic value:
    • the dividend valuation model, which estimates the intrinsic value of a stock by calculating the present value of the future dividends expected. Constant growth rate, perpetual growth rate, sustainable growth rate, and two-stage dividend growth rate models are formulated based on different assumptions of growth rates. Thus, the model is sensitive to the choice of growth rate and discount rate, which are difficult to estimate. A major shortcoming of the dividend valuation model is that it could not be used to value stocks of nondividend paying companies. 
    • The price multiples can be used for all companies regardless of the dividend payment policy. Most widely used price multiple is the price/earnings ratio; however, price to cash flow, price to sales, or price to book value ratios are also employed in the valuation process.

In short, the tasks of an individual investor who wishes to follow the valuation procedures of the fundamental approach are as follows:
  1. Estimation of earnings per share (EPS) for the next period.
  2. Estimation of the investor’s required rate of return (r), which is used as a discount rate in the dividend valuation model. It reflects the risk of the company stock.
  3. Estimation of the expected growth rate (g) of the earnings or the dividend stream.
  4. Estimation of the payout (or retention) ratio.
It should, strongly, be emphasized that the above-mentioned parameters are induced to change by the changes at the economy, industry, and company levels. These changes introduce immense difficulties in the estimations of EPS, r, g, and the payout (or retention) ratio.