Fundamental Analysis on Financial Markets

What is fundamental analysis?

Fundamental analysis is a comprehensive examination of a company's financial health, with the primary goal of determining its "fair value" also known as intrinsic value. This analytical approach delves deep into a company's balance sheets, income statements, and cash flow statements, offering a multifaceted view of its financial performance.
The concept of fair value is rooted in the idea that the price of a share of stock should reflect a company's ability to generate profits in the foreseeable future. However, predicting future financial outcomes is inherently uncertain due to various external factors, market dynamics, and economic fluctuations. Therefore, it is crucial to recognize that there is no definitive, unchanging "correct" fair value for a company's stock.
Instead, fundamental analysis provides a means to estimate this fair value by evaluating a myriad of factors. Analysts consider a company's historical financial data, its competitive position within its industry, the quality of its management team, and broader economic trends. By carefully weighing these factors, analysts can arrive at a reasoned estimate of a stock's intrinsic value.
In essence, fundamental analysis is a tool that aids investors in making informed decisions about buying or selling stocks, grounded in a thorough understanding of a company's financial health and its potential for future profitability. While it doesn't offer a precise figure for fair value, it offers a valuable framework for investors to assess the relative attractiveness of a stock in light of the uncertainties inherent in the financial markets.

Fundamental analysis and financial statements

Fundamental analysis is a meticulous process that often begins with a thorough examination of a company's balance sheet. The balance sheet is a critical financial statement that provides a snapshot of a company's financial position at a specific point in time. It lists a company's assets, liabilities, and shareholders' equity. These elements are essential building blocks for understanding a company's overall financial health.
Assets, which encompass everything a company owns, can be tangible (like machinery and real estate) or intangible (like patents and trademarks). Liabilities represent the company's obligations, including debts, accounts payable, and other financial commitments. Shareholders' equity reflects the residual interest in the company's assets after deducting its liabilities.
Analyzing the balance sheet involves assessing the composition and quality of these components. For instance, analysts might evaluate the liquidity of the assets—how easily they can be converted into cash—as this indicates the company's ability to meet its short-term obligations. Additionally, examining the debt levels and the mix of short-term and long-term debt on the balance sheet helps assess the company's financial risk.
Once a comprehensive understanding of the balance sheet is gained, fundamental analysts proceed to calculate the company's intrinsic value or 'fair value.' This value represents what the stock should be worth based on the company's financial health, growth potential, and other fundamental factors. It is a fundamental analyst's estimation of the true worth of the company, irrespective of market sentiment. The key insight gained from this analysis is the ability to compare the calculated intrinsic value to the current market price of the company's shares. If the market price is lower than the intrinsic value, the stock is considered undervalued. This implies that there may be a discrepancy between the stock's true worth and its market price.
For investors, an undervalued stock presents an opportunity. It suggests that the market has not yet recognized the stock's full potential or has temporarily discounted it for various reasons. In such cases, investors may consider purchasing the stock with the expectation that over time, the market will correct this 'error,' causing the share price to rise closer to its intrinsic value. This concept is at the heart of value investing, where investors seek out undervalued assets in the hopes of profiting from their future appreciation.
In summary, fundamental analysis, beginning with a careful examination of the balance sheet, provides investors with a structured approach to evaluate the financial health of a company and estimate its intrinsic value. By comparing this intrinsic value to the current market price, investors can make informed decisions about whether a stock is over or undervalued, potentially identifying profitable investment opportunities in the process.

Warren Buffett and other value investing gurus

Warren Buffett, often referred to as the "Oracle of Omaha," is undoubtedly one of the most renowned and successful investors in history. His investment strategy is deeply rooted in fundamental analysis, a philosophy he acquired directly from his mentor and the father of value investing, Benjamin Graham. Graham's groundbreaking work on value investing, notably laid out in his book "Security Analysis," became the cornerstone of Buffett's investment philosophy. Their connection began when Buffett studied under Graham at Columbia University, and it has since shaped his approach to the stock market.
But Buffett is not alone in his commitment to fundamental analysis and value investing. There exists a global community of investors who share this philosophy, and some of the most prominent names in this circle include Joel Greenblatt, Mario Gabelli, Charlie Munger and Peter Lynch. Each of these individuals has achieved remarkable success by adhering to the principles of analyzing a company's intrinsic value and patiently waiting for the market to recognize and correct any mispricing. What unites these investors is their unwavering patience. Once they identify an undervalued asset, they are prepared to hold their investments for the long term, sometimes even for years or decades. This patience is grounded in the belief that the market, over time, tends to converge toward rational valuations. It acknowledges that short-term market fluctuations and sentiment-driven price movements can create opportunities for value-oriented investors.
For example, when an undervalued stock is purchased, it may not immediately gain traction in the market. However, these investors have the discipline to wait patiently, allowing the company's underlying fundamentals to materialize and the market to eventually recognize the stock's true worth. This patience is a cornerstone of their success, as it differentiates them from those who are swayed by short-term market volatility or seek quick profits.
In essence, investors like Warren Buffett, Joel Greenblatt, Mario Gabelli, Charlie Munger and Peter Lynch, embody the principles of value investing, emphasizing the importance of rigorous fundamental analysis and the virtue of patience in capitalizing on market inefficiencies. Their success stories serve as a testament to the enduring power of these investment philosophies in navigating the complex and dynamic world of finance.

The financial statements

The consolidated financial statements are the financial statements that show the balance sheet and economic performance of a group of companies controlled by the same parent company that prepares them.

In the case of groups of companies, the consolidated financial statements are the document that makes up for the lack of information in the financial statements of companies with significant shareholdings, since the financial statements of such companies have little information value.

For this reason, the consolidated financial statements are the only instrument that can provide a fair and true representation of the balance sheet and profit and loss account of a group.

The balance sheet

The Balance Sheet, also known as the Statement of Financial Position, is a vital financial document that provides a snapshot of a company's financial condition at a specific point in time, typically at the end of a fiscal period, such as a quarter or a year. It serves as a fundamental component of a company's financial statements, alongside the income statement and the cash flow statement.
The balance sheet is structured into two main sections: assets and liabilities. These sections are designed to offer a clear and concise overview of how a company's resources are allocated and how those resources are financed.
Let's explore these sections in greater detail:

1. Assets: The asset section of the balance sheet encompasses everything a company owns, including both tangible and intangible assets. Here's a breakdown of key asset categories:
   1. Current Assets: These are assets expected to be converted into cash or used up within one year. Common examples include cash and cash equivalents, accounts receivable (money owed to the company by customers), and inventory.
   2. Non-Current Assets: These assets are not expected to be converted into cash within a year. They encompass long-term investments, property, plant, and equipment (such as buildings and machinery), and intangible assets like patents and trademarks.
   3. Other Assets: This category may include less common assets like deferred tax assets, investments in subsidiaries, or goodwill.
2. Liabilities: The liability section of the balance sheet represents the sources of financing used to acquire the assets listed in the asset section. Key liability categories include:
   1. Current Liabilities: These are obligations expected to be settled within one year. They include items like accounts payable (money owed to suppliers), short-term debt, and accrued expenses.
   2. Non-Current Liabilities: These are long-term obligations that are not due within a year. Examples include long-term loans, bonds payable, and deferred tax liabilities.
3. Equity: Also referred to as shareholders' equity or owner's equity, this represents the residual interest in the assets of the company after deducting liabilities. It includes common stock, retained earnings (accumulated profits), and additional paid-in capital.

The balance sheet is aptly named because it adheres to the accounting equation: Assets = Liabilities + Equity. This equation ensures that the company's resources (assets) are financed either through debt (liabilities) or ownership (equity). Analysts, investors, and creditors often scrutinize the balance sheet to assess a company's financial stability, liquidity, and solvency. It helps stakeholders understand how a company allocates its resources, its ability to meet short-term and long-term obligations, and its overall financial health. Moreover, it provides essential information for calculating financial ratios, such as the debt-to-equity ratio and the current ratio, which aid in evaluating a company's financial performance and risk. In summary, the balance sheet is a critical financial statement that provides a snapshot of a company's financial position, showcasing its assets and liabilities, and serving as a foundational tool for assessing its financial health and making informed financial decisions.

The income statement

TThe Profit and Loss Account (P&L), also commonly known as the Income Statement or Statement of Income, is a pivotal financial statement that offers a comprehensive view of a company's financial performance over a specific period, typically a year, quarter, or month. Its primary objective is to outline the company's revenues, expenses, gains, and losses during that time frame, ultimately determining whether the company generated a profit or incurred a loss.
The P&L account is structured into several sections, each providing valuable insights into the financial health of the company:

1. Revenues: Revenues, also referred to as sales or income, represent the total amount of money generated from the company's primary operations. This includes income from selling products, services, or any other sources of revenue. For example, a retail company's revenue would consist of the sales of its merchandise.
2. Cost of Goods Sold (COGS): COGS represents the direct costs associated with producing or delivering the goods or services that generated the company's revenue. This category includes expenses such as raw materials, labor, and manufacturing overhead. Subtracting COGS from revenues yields the gross profit.
3. Equity: Also referred to as shareholders' equity or owner's equity, this represents the residual interest in the assets of the company after deducting liabilities. It includes common stock, retained earnings (accumulated profits), and additional paid-in capital.
4. Gross Profit: Gross profit is the difference between total revenues and the cost of goods sold. It indicates how efficiently a company can produce or deliver its products or services. It's a critical measure of profitability before considering operating expenses.
5. Operating Expenses: Operating expenses include all costs not directly tied to the production of goods or services. These expenses cover items like salaries, rent, utilities, marketing, research and development, and other overhead costs. Subtracting operating expenses from gross profit gives the operating profit or loss.
6. Other Income and Expenses: This section includes gains and losses that are not part of the core operating activities. For example, interest income, interest expenses, gains or losses from the sale of assets, and other non-operating items.
7. Net Profit (or Loss): The final section of the P&L summarizes the company's bottom line, indicating whether it made a profit or incurred a loss for the specified period. If revenues exceed expenses, the result is a positive net profit (profit). Conversely, if expenses surpass revenues, it results in a negative net profit (loss).

The P&L serves as a crucial tool for assessing a company's financial performance, helping stakeholders understand its ability to generate profit from its core operations and manage its expenses effectively. It also provides valuable data for analyzing trends in revenue and expenses over time, making it an essential tool for financial decision-making and strategic planning.
Investors, creditors, and analysts rely on the P&L to gauge a company's profitability, evaluate its financial health, and make informed investment or lending decisions. Additionally, the P&L is a key component in the calculation of various financial ratios, such as the earnings per share (EPS), price-to-earnings (P/E) ratio, and return on investment (ROI), which offer further insights into a company's financial performance and valuation.
In summary, the Profit and Loss Account is a fundamental financial statement that provides a comprehensive overview of a company's financial performance, detailing its revenues, expenses, gains, and losses, and ultimately determining whether it achieved a profit or incurred a loss during a specific reporting period. It is a vital tool for assessing financial health, making investment decisions, and strategic planning.

How to calculate the fair value of a stock: evaluation methods

There are several methods of company valuation, here are the main ones.

Which valuation method is better to use in order to calculate the fair value of a stock?

Calculating the fair value of a corporation is a multifaceted process, and there are various approaches and methods available to assess it. Every method has its strengths and weaknesses and may be better suited to particular scenarios, industries, or types of businesses.

The Limitations of Singular valuation Methods
Using a single valuation method can have limitations.

1. Subjectivity: Different methods can produce significantly different fair value estimates due to variations in assumptions and data inputs. Relying solely on one method might lead to an incomplete or biased valuation.
2. Inadequate Representation: Using only one method might not capture the full spectrum of value drivers and risks inherent in a company. It may oversimplify complex financial situations.
3. Market Dynamics: Market conditions and investor sentiment can fluctuate, affecting stock prices and the relevance of specific valuation methods. One method might be more suitable during bullish markets, while another could be more appropriate during bearish times.

The Benefits of Averaging Results
Averaging the fair value estimates obtained from multiple valuation methods can offer several advantages

1. Balanced Assessment: By considering several approaches, you can create a more balanced and comprehensive view of a company's value. This helps mitigate the biases and limitations of individual methods.
2. Risk Mitigation: Diversifying the valuation process by using various methods can help identify potential outliers or errors in a single calculation, reducing the risk of making significant investment or financial decisions based on flawed data.
3. Smoothing Volatility: Some methods can be sensitive to short-term fluctuations in financial metrics or market conditions. Averaging results can help smooth out such volatility and provide a more stable estimate of fair value.
4. Enhanced Confidence: When stakeholders, investors, or decision-makers see that multiple methods yield similar fair value estimates, it can increase their confidence in the valuation results.
5. Robust Decision-Making: Averaging results fosters a more robust decision-making process, as it encourages a more comprehensive evaluation of a company's intrinsic worth. It also acknowledges that fair value can be a subjective concept influenced by various factors.

In summary, there is no universally superior method for calculating corporate fair value. The practice of averaging results from multiple calculation methods can provide a more robust, balanced, and reliable assessment of a company's fair value, helping stakeholders make more informed financial decisions. However, it should be done thoughtfully, with consideration of the unique characteristics and dynamics of the business being valued.

In the Forecaster Terminal we average the different valuation method results by default, at any time you can choose which method to switch off, if you are not satisfied with the result.