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Fundamental Analysis on Financial Markets

18 min

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 annual financial statement is a document prepared by a company in order to determine the income earned by the company during the administrative period under consideration (financial year) and the working capital existing at the end of the same period.
The annual balance sheet consists of:

  1. balance sheet;
  2. income statement;
  3. explanatory notes to 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 consolidated financial statements consist of:

  1. balance sheet;
  2. profit and loss account;
  3. explanatory notes to the financial statements;

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).
  8. 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.

The Discounted Cash Flow (DCF)

The Discounted Cash Flow (DCF) method stands as one of the most widely recognized and respected approaches in contemporary business valuation and investment analysis. It forms the cornerstone of financial modeling and decision-making, offering a robust framework for estimating the intrinsic value of a company's equity. Conceptual Foundation: At its core, the DCF method asserts that the value of a company's equity is contingent on the present worth of the cash flows it is expected to generate in the future. In other words, it recognizes that the true value of a company is based on its ability to produce cash flow over time. However, it takes into account the time value of money, acknowledging that a dollar received in the future is not as valuable as a dollar received today. Therefore, future cash flows are discounted back to their present value, reflecting their reduced worth when received in the future.

Calculation Process: The DCF calculation involves several key steps: Forecasting Cash Flows: It begins with forecasting the company's expected future cash flows. These cash flows typically comprise operating cash flows, which represent the cash generated from core business operations. Selecting a Discount Rate: An essential element of the DCF analysis is the selection of an appropriate discount rate, often referred to as the discount rate or the required rate of return. This rate reflects the risk associated with the investment and serves as the benchmark for discounting future cash flows. It is typically based on the company's cost of capital, which considers factors such as the risk-free rate, market risk premium, and the company's specific risk. Discounting Cash Flows: Using the chosen discount rate, each projected future cash flow is discounted back to its present value. The formula used for this purpose is: DCF = CF1 / (1 + r)^1 + CF2 / (1 + r)^2 + ... + CFn / (1 + r)^n

DCF is the discounted cash flow or the present value of all future cash flows. CF1, CF2, ..., CFn represent the expected cash flows for each period. r is the discount rate. n is the number of periods into the future for which cash flows are projected.

Terminal Value: After the explicit forecast period, a terminal value is calculated. This represents the present value of all cash flows beyond the forecast period. Common methods for calculating terminal value include the perpetuity growth model (Gordon Growth Model) or the exit multiple method. Summing Cash Flows: Finally, the present value of the expected operating cash flows for the forecast period and the terminal value are summed to arrive at the total DCF, which represents the estimated intrinsic value of the company. In summary, the DCF method is a comprehensive and widely embraced approach for valuing companies and investments. It takes into account the future cash flows generated by a company and adjusts them for their present value, accounting for the time value of money and the risk associated with the investment. This method empowers analysts, investors, and financial professionals to make informed decisions by estimating the fair value of assets and companies in a systematic and rigorous manner.

The DCF method is the one used by Benjamin Graham (and consequently Warren Buffett ) to calculate the fair value of shares. This method is present within the Forecaster terminal.

The income and Asset valuation method

Income Method: The Income Method is a widely used approach in business valuation that assesses the value of a company based on its ability to generate income and profits over time. This method primarily focuses on the company's expected future income streams. Here's a more detailed breakdown: Expected Income: The Income Method involves forecasting the company's expected income, often measured by financial metrics like Return on Equity (ROE), for each financial year within a projection period. This projection period typically spans several years into the future.

  1. Discounting Future Income: Once the expected income for each year is estimated, these income figures are then discounted back to their present value using an appropriate discount rate. The discount rate reflects the cost of capital or the required rate of return, considering the risk associated with the investment.
  2. Terminal Value: In addition to the projected income for the forecast period, the Income Method also considers a terminal value. This represents the expected income that the company will generate beyond the projection period. The terminal value is calculated using methods such as the perpetuity growth model or exit multiple approach.
  3. Summation: Finally, the present value of the expected income for each year in the projection period and the terminal value is summed to determine the total estimated value of the company.
  4. The Income Method is particularly useful for companies with a history of stable and predictable income streams, making it a valuable tool for valuing operating businesses in various industries.
  5. Asset Method: The Asset Method, on the other hand, is less commonly employed in business valuations, as it is typically applicable to a specific subset of companies. Here's a deeper look at this method:
    1. Asset-Centric Valuation: The Asset Method places a primary emphasis on the company's assets, rather than its income or earnings potential. It is most often used when the assets held by the company possess significant, independent, and substantial value. This method aims to determine the value of the company based on the net worth of its assets.
    2. Applicability: The Asset Method is frequently employed in cases where the company does not engage in active operational activities and serves more as a holding entity or a container of assets. Examples of companies where the Asset Method may be applicable include real estate companies, investment holding companies, or entities primarily focused on managing and holding valuable assets like land, real estate, or investments in other businesses.
    3. Asset Valuation: In this approach, the value of each individual asset is assessed, often based on market values or appraisals. These values are then aggregated to determine the total asset value of the company. This method is more prevalent in situations where the value of the assets significantly exceeds the earnings potential of the business.

In summary, the Income Method and Asset Method are two distinct approaches to business valuation, each suited to specific circumstances. The Income Method is widely used for valuing operating businesses with predictable income streams, while the Asset Method is reserved for cases where the assets themselves hold substantial and independent value, often found in real estate and holding companies. Choosing the appropriate valuation method depends on the nature of the company, its financial characteristics, and the specific context of the valuation. Often these two methods are used in synergy, resulting in the Mixed Equity-Earnings Method.
The Mixed Capital-Income Method offers a balanced approach to business valuation by integrating the valuation of assets and income. It acknowledges that in certain cases, neither a sole focus on assets nor a sole focus on income can fully capture the company's intrinsic value. Therefore, this method seeks to provide a more comprehensive and nuanced assessment of a company's worth, tailored to the specific circumstances of the valuation.

Economic Value Added (EVA) valuation method

Economic Value Added (EVA) is a valuation methodology that offers a distinctive and complementary perspective on a company's value compared to the Discounted Cash Flow (DCF) method. It is particularly valuable in the context of assessing a company's performance and its alignment with the goal of maximizing shareholder value. Here's a more comprehensive look at EVA

  1. Objective: Maximizing Shareholder Value
    EVA is fundamentally concerned with measuring a company's performance in relation to the overarching objective of maximizing shareholder value. Unlike some other valuation methods, EVA is explicitly focused on determining how effectively a company creates value for its shareholders.
  2. Profit After Cost of Capital
    At its core, EVA quantifies the value created for shareholders by examining the profit that remains after deducting the cost of the invested capital used to generate that profit. This concept is rooted in the notion that a company should generate returns that exceed the cost of the capital it deploys.
  3. Focus on Historical and Medium-Term Performance
    One notable difference between EVA and the DCF method is their focus on different time frames. While DCF primarily relies on discounting future cash flows, EVA places considerable emphasis on explaining a significant portion of a company's value based on its historical performance as well as medium-term growth expectations. In essence, EVA not only considers the results a company is expected to achieve in the future but also evaluates its performance up to the present.

Components of EVA:
EVA calculations typically involve assessing the company's historical financial performance, including metrics such as operating profit, the cost of capital, and the capital employed. By comparing the return generated on the invested capital to the cost of that capital, EVA provides insights into whether the company is creating value or destroying value for shareholders. Aligning Performance and Value Creation: One of the key advantages of EVA is its ability to align performance measurement with value creation. Companies that consistently achieve positive EVA are deemed to be creating value for shareholders, while those with negative EVA may be destroying value.

Strategic Insights
EVA is not only a valuation tool but also a strategic management framework. It can guide decision-makers in understanding how specific actions and investments impact the company's ability to create value. This makes it a valuable tool for corporate performance evaluation and strategic planning. In conclusion, EVA represents a distinct approach to assessing a company's value and performance. It is centered on the goal of maximizing shareholder value and provides a unique perspective by considering historical performance and medium-term growth expectations. EVA not only serves as a valuation methodology but also as a strategic tool that helps companies align their actions with the objective of creating value for their shareholders. This method is present within the Forecaster terminal.

Peter Lynch valuation method

Peter Lynch is the former manager of the Magellan and Fidelity funds from 1977 to 1990, famous for having had an average performance during this period of 29.2%. Peter Lynch is celebrated not only for his impressive track record as a fund manager but also for his straightforward and effective investment philosophy. One of his key principles, as articulated in his book "One Up On Wall Street", revolves around the concept of the P/E ratio and its connection to a company's growth rate.

"The p/e ratio of any company that's fairly priced will equal its growth rate ... If the p/e of Coca-Cola is 15, you'd expect the company to be growing at about 15 percent a year, etc. But if the p/e ratio is less than the growth rate, you may have found yourself a bargain. A company, say, with a growth rate of 12 percent a year ... and a p/e ratio of 6 is a very attractive prospect. On the other hand, a company with a growth rate of 6 percent a year and a p/e ratio of 12 is an unattractive prospect and headed for a comedown." "In general, a p/e ratio that's half the growth rate is very positive, and one that's twice the growth rate is very negative."

(Peter Lynch)

Lynch asserts that a fairly priced company will have a P/E ratio that is approximately equal to its growth rate. In other words, if you're evaluating a stock and you find that its P/E ratio is roughly in line with its expected annual growth rate, it suggests that the market has reasonably priced the stock in relation to its growth prospects.

A key takeaway from Lynch's perspective is that when a company's P/E ratio is lower than its growth rate, you may have stumbled upon a bargain. For instance, if a company has a growth rate of 12% per annum and a P/E ratio of 6, it appears to be an attractive investment opportunity. This scenario suggests that the market is undervaluing the company's growth potential, potentially making it a hidden gem.

Conversely, Lynch cautions against investments in companies where the P/E ratio is higher than the growth rate. For example, if a company has a growth rate of 6% per annum but carries a P/E ratio of 12, it's considered an unattractive prospect. This situation implies that investors are paying a premium for a company with limited growth potential, and such investments are more likely to underperform.

Lynch provides a practical rule of thumb: a P/E ratio that is approximately half the growth rate is viewed as very positive. On the other hand, a P/E ratio that is approximately twice the growth rate is perceived as very negative. This rule simplifies the assessment of whether a stock is potentially undervalued or overvalued based on this relationship.
In summary, Peter Lynch's investment philosophy regarding the P/E ratio and growth rate offers a practical and intuitive way for investors to assess the relative value of stocks.
This method is present within the Forecaster terminal.

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.

Calculate the fair value for every listed company now!

19th March, 2024