In contrast to technical analysis, fundamental analysis is not concerned with stock chart data.
Instead, fundamental analysis is about assessing the underlying business, it’s balance sheet, financial health as well as other external economic factors.
For investors that mostly utilize fundamental analysis, the intention is to identify stocks that represent worthwhile investments by comparing the ‘fundamental’ value of the company with the market capitalisation.
If the market capitalisation of a stock is too high in comparison to the underlying value of the company, some investors that utilize fundamental analysis will steer clear of that stock.
On the other hand, even if a stock has a comparatively high market capitalisation, other investors may still invest as long as they believe that the company will grow substantially in the long term.
A simple method that fundamental analysts use to assess the real value of a company is called net asset value.
The idea is very simple, it is essentially a calculation of the value of the company when you subtract the liabilities from the assets and cash.
The formula is simply: (total assets + cash) – total liabilities.
Let’s think about an example.
If a company has $20,000,000 in assets, $5,000,000 in cash and $8,000,000 in liabilities, the formula would be ($20m + $5m) – $8m = $17m.
So, the net asset value of the underlying business would be $17m. This figure can be used to assess how close a company’s stock is to the true value of the company.
For instance, if the market capitalisation of our example company was $250m, then we may decide that it’s not a worthwhile investment as the net asset value is just $17m.
Likewise, if the market capitalisation of the company was $6m, we might decide to invest as it is a bargain.
It’s important to note that valuation is more complex in reality. The market capitalisation of a firm may be high compared with the net asset value because the company is expected to have enormous growth in the next 5 years. Equally, it the market cap may be lower than the net asset value if investors believe that the company is going out of business soon.
You can definitely get bargains in the stock market, you simply need to do a lot of research to examine whether a stock will go up or down in the future. Nonetheless, net asset value gives you an idea of how the true underlying value of a company stacks up against it’s valuation on the stock market.
This is a simple, yet useful tool, that helps investors to determine a margin of safety.
The discounted cash flow method can be a little tricky to understand. In short, it’s a calculation that is used to estimate the value of a company based on it’s expected future cash flows.
This method is used widely in the business world, enabling business owners to examine whether any changes to their business would be a good idea or not.
The formula for the discounted cash flow model is as follows….
Discounted cash flow = (CF1^1/(1+r)^1) + (CF2/(1+r)^2) + (CF3/(1+r)^3) + (CF4/(1+r)^4) + (CF5/(1+r)^5)
r is known as the discount rate, which represents the weight average cost of capital (WACC) of a company.
The WACC of a stock can be found with a Google search, however the formula is as follows: Market capitalisation/(market cap + debt) x cost of equity + debt/(market cap + debt) x cost of debt x (1−corporate tax rate)
The most tricky element of the WACC calculation is the cost of equity, which is essentially the money that the company has to pay in order to grow the share price. This can be hard to assess.
One formula could be: risk free rate of return + Beta x (average market rate of return – risk free rate of return).
The risk free rate is usually the rate of a 10 year gilt bond – which is 0.402% today.
Anyway, going back to the original discounted cash flow calculation. We will assume that our example company has a WACC of 6%.
As analysts, we might project that our example company will have cash flows that increase by $1m each year, for the next 5 years.
So in year 1, the cash flow could be $5m, $6m in year 2, $7m in year 3, $8m in year 4 and $9m in year 5.
Our discounted cash flow calculation would look something like this…
($5m/(1+0.06)^1) + ($6m/(1+0.06)^2) + ($7m/(1+0.06)^3) + ($8m/(1+0.06)^4) + ($9m^5/(1+0.06)^5).
The result of this input would be $28,996,367.62.
You then need to divide this number by the number of shares that a company has outstanding.
If a company has 1,000,000 shares outstanding, you’d have to divide $28,996,367.62 by 1,000,000, which would be $28.99.
If the current stock price of the company is above that figure (say $35), then it wouldn’t represent a good investment.
On the other hand, if the stock price is well below that figure (say $18), then it would represent a good investment opportunity.
The most difficult thing about the discounted cash flow method is in estimating the future cash flows. An easy way to do this is to look at the past performance of the cash flows of a company and to calculate the average. You’d then apply this average percentage change to future cash flows.
For instance, if a company’s cash flows grew by 15% a year and the company had a cash flow of $10m in 2020, the projected cash flow for the first year could be $11.5m. In years 2,3,4 and 5, you’d simply multiply each figure from the previous year by 1.15.
The need to project future cash flows is the greatest flaw of this method. The reason is that anything can happen in the future.
Companies don’t always do as expected on paper, unexpected things can happen in business to hamper or accelerate progress.
For instance, it’s almost impossible to predict the hiring or firing of a key employee, the occurrence of a financial crisis or the success of a new product. All of which would dramatically impact upon the cash flows that a company generates.
Earlier on in this course, we discussed P/E ratios and P/B ratios. Both of which are quick tools that a fundamental analyst could use to contrast the price of stock with the underlying performance of a company.
A quick reminder, if a company has a P/E ratio of 15, then we know that investors are paying $15 for every $1 that the company earns as net income.
If a company has a P/B ratio of 2, then it suggests that investors are paying $2 for every $1 that the company has in assets.
Both of these ratios are known as multiples and then can be utilised in a valuation model called the comparables model.
In short, the main concept of the comparables model is that stocks should be priced in a similar way to other stocks in a similar category.
For example, with the comparables model, an investor could compare the value of stocks that operate in the technology sector.
If there are significant differences between stocks, opportunities for investment could be found.
A company could be valued less than other companies in the same sector, which could suggest that the firm is undervalued. In this scenario, it could be a buying opportunity as the stock price is set to rise in line with other stocks in the same industry.
On the other side, if a company is valued much higher than it’s rivals, it could suggest that it is overvalued. In this situation, it could be reasonable to short sell the stock, profiting as the stock price goes down.
This is obviously a very simplistic approach to investing as company-specific information could be driving the price anomaly. Doing research on the latest announcements from an individual company is the best way to avoid bad investments.
Anyway, where the multiples come in is that they are used to compare one stock with the other stocks in the same category.
For example, if technology stocks in the USA have a P/E ratio of 45 on average, if one specific firm has a P/E ratio of 22, it could be a buying opportunity as it is priced well below it’s peers.
The final method from fundamental analysis that we will discuss in this lesson is called ‘Enterprise Value’.
Enterprise value is a measure of a company’s total value.
It calculated using the following formula: Market Capitalisation + All Debt – Cash (or cash equivalents).
So if a company had a market capitalisation of $50m, with debt to the value of $5m and cash to the value of $15m.
The calculation would be $50m + $5m – $15m, which is obviously $40m. So, the enterprise value of this example company would be $40m.
It’s important to note that the enterprise value is different to the true value of the underlying business. Instead, it represents a fair value that investors should be willing to pay in order to buy the firm. So in short, it represents investor sentiment.
Many consider enterprise value to be more accurate than market capitalisation. The reason is that it includes fundamental information with regard to cash and debt.
As a consequence, you can compare the enterprise value with the market capitalisation to assess whether a company is under or over valued.
The flaw of enterprise value is that it is not know how companies are using the debt. Many companies may be very capital intensive and so they may be using a lot of short term debt capital to benefit their short term operations.