What is fundamental analysis
Fundamental analysis is a stock picking strategy through which the investor tries to identify the companies that have an underlying value that will positively impact its current and future business. This analysis is done by reviewing the economic fundamentals of a company and/or market and then estimating future performance. When applying fundamental analysis, you should be asking yourself questions such as “Is revenue growing?” , “Are margins deteriorating?”, “How much debt does the company have”, “Are they making a profit and will it continue to grow?”. The number of questions you could ask yourself are almost limitless because anything that will impact the economic wellbeing of a company in the future should be considered as part of fundamental analysis.
When applying fundamental analysis, you are trying to measure the intrinsic value of a company. This gives you an indication of what the business is worth so you can determine when the price has reached a point that your should buy it.
One of the key determinants of the intrinsic value of a stock is cash flow. The value of a stock is a function of the present value of its future cash flows. You want to find companies that are generating a healthy cash flow today that you predict will continue to increase it in the future. Shareholders benefit from free cash flows because the company can use this cash to pay dividends to the shareholders, buy back shares which can cause the remaining shares to appreciate or they can reinvest this cash in the business (through an acquisition or expansion that will increase profitability).
Since a dollar received today is worth more than a dollar worth tomorrow (time value of money), an investor using fundamental analysis to choose a stock should be willing to pay more for a company that is profitable now and has a low level of risk associated with it compared to a high risk company that promises to deliver the same profit in the future. The discount rate used to determine the present value of future cash flows of the profitable, low-risk company is lower than the discount rate that the investor would use for not-yet profitable, high-risk company. The lower the discount rate the investors uses when valuing a company the more they would be willing to pay for the company today.
So now that we know that the higher the level of risk involved with a company the higher the discount rate we will use, how do we determine what that discount rate should be? Unfortunately, there is no simple answer. If you haven’t already done so, we strongly suggest that you read “The Five Rules for Successful Stock Investing” by Pat Dorsey. This investing guide is extremely useful for investors who are considering buying individual stocks. There is a chapter entirely dedicated to the topic of intrinsic value and factors to consider when determining the appropriate discount rate to use.
Some of the factors to consider when determining the appropriate discount rate to use include the size of a company (smaller companies are generally a higher risk), financial leverage (a company with more debt has a higher level of risk), Cyclicality (if the company operates in a cyclical industry such as semiconductors where it is more difficult to forecast future cash flows, a higher level of risk is involved), Management/Corporate governance, Economic Moat (the stronger the competitive advantage, the less riskier the company is), and Complexity (the more complex business and/or financial structure, the more risk is involved).
One of the basic assumptions of fundamental analysis is that in the long run, a stock’s price will reflect its fundamentals. This is why a stock should be purchased only when the share price is below what you determine to be the intrinsic value of the company. For example, if you determine the intrinsic value of a company to be $40 and the stock is currently trading at $60, it is not the right time to purchase that stock. You want to only buy a stock when it is trading at a discount to its intrinsic value and the riskier the business, the larger the discount should be.
One of the downfalls of fundamental analysis is that it is based on estimates of future stock prices, forecasts of revenue and dividend payouts which are then used to calculate the present value of the stock which is not an easy task. Ensuring that you only buy stocks that are priced below their intrinsic value (which results in a margin of safety) will help reduce (but never eliminate) risk if you make errors in your forecasts of the future.