Secrets of Fundamental Analysis

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Indexes
  1. Dividend Discount Model
  2. Discounted Free Cash Flow
Secrets of fundamental analysis in stock investing

Understanding Fundamental Analysis

Fundamental Analysis is an approach used by investors to determine the fair value of a stock by examining various qualitative and quantitative indicators. This value is then measured against the current price of the stock to see if a company is overvalued or undervalued.

While Technical Analysis aims to forecast the future price of a stock through historical indicators such as price & volume, Fundamental analysis is independent of the market price.

Fundamental Analysis involves Macroeconomic Factors such as central bank interest rates, GDP growth & inflation, and Company-specific factors such as revenues, growth & profits.

The various Qualitative and Quantitative factors used by analysts to understand the value of a business are described as follows.

Qualitative Analysis

Qualitative Factors that determine the long-term prospects of a company include the business model, competitive advantages, corporate governance policies, market share, size & growth of the overall industry regulation, and customer base.

For instance, Google, which has a market cap of nearly $2 Trillion has a virtual monopoly across search & advertising, enabling it to reap the rewards by gradually increasing prices. In contrast, a company like the New York Times has a low barrier to entry, as nearly anyone can compete against them through a website/blog.

Companies that drive shareholder value creation over the long-term tend to capture market share quickly, create products/services that are hard to replicate and acquire competitors that may pose a competitive risk.

Qualitative Factors can also tie into the various macroeconomic factors that drive the market. For instance, equities that improved the experience for customers staying at homes such as Fitness Company Peloton, Video Communications Company Zoom, and Entertainment Company Netflix, all saw a risk.

Nearly two years later, with the pandemic ending, these stocks are reverting to their original prices.

Quantitative Analysis

Investors can understand the quantitative factors that impact a company’s fair value by looking at the information displayed in the financial statements.

The key financial statements that help assess the operational performance of a company are the Income Statement, the Balance Sheet & the Cash Flow Statement.

The Income Statement paints a picture of the performance of a business over a year and includes details about the company’s revenues, margins, and profitability.

The balance sheet helps investors understand the resources that a business owns at any point including materials, buildings, cash & inventory (Assets), the debt that it owes to outside creditors (Liabilities), and the profits it has retained over the years (Equity).

The statement of cash flow is the final piece of the puzzle as it records all the cash transactions conducted in a year from operating, investing, and financing activities.

You can see more details about how to read Earning Reports in the video below:

Using the information from the Income Statement, Balance Sheet & Statement of Cash Flows, investors can derive the intrinsic value for stock through a host of valuation techniques. These include:

Relative Valuation Methods

Relative Valuation Technique is a technique whereby investors compare the financials of a stock against its competitors, other companies in the industry, or its historical performance to determine if it is overvalued or undervalued.

There are many different ratios that investors use to compute relative valuation, including EV/EBITDA, Price/Sales, Price/Earnings, and so on.

Price/Earnings — The Price/Earnings or PE Ratio is the most common valuation technique used by investors to gauge the value of a company. The PE Ratio is estimated as follows:

Calculation of PE ratio (Price to Earnings ratio) formula

For example, Microsoft Stock currently trades at $285 per share, with earnings per share of $7.47 per share in the last year. Based on this, the company is trading at a P/E of 38.32.

As a rule of thumb, a company with a lower P/E compared to its competitors is generally considered undervalued, however, the average P/E can vary based on the type of industry.

Price/Sales — The Price/Sales ratio measures the price of a company’s stock against its annual sales. The P/S measure is a reliable estimate when looking at a high-growth stock without having any earnings.

For example, Tesla trades at a high P/E multiple of 330x, but it is more reasonable at 24x sales.

Absolute Valuation Methods

Absolute Value, which is popularly known as intrinsic value, is a technique that helps investors determine the financial worth of a company based on its projected cash flows/dividend payments.

Unlike relative valuation methods that rely on the market to estimate the fair value, absolute valuation methods use the company’s financials to estimate value. The most popular absolute valuation methods are -

Dividend Discount Model

The dividend discount model is a quantitative method for predicting the stock price of the company by estimating the sum of all future dividend payments that are discounted back to the present value.

The Dividend Discount Model is most effective for companies that have predictable growth in their dividend payments such as financial/utility companies.

To understand how the DDM works let’s look at the example of Bank of America. The stock is currently trading at $43, with an annual dividend payment of $0.78 per share. If we assume that the cost of equity for BoA is 6% and that dividends will grow at 4% annually, the intrinsic value for BoA can be estimated as follows -

Price Per Share = 0.87/(0.06–0.04) = $43.5

This implies that the stock has a fair value of $43.5 and is undervalued at any price below this.

Discounted Free Cash Flow

The Discounted Free Cash Flow method estimates the intrinsic value of a stock as the present value of all future cash flows. The DCF method is best suited for companies that aren’t profitable or don’t currently pay dividends. The free cash flows of a firm are estimated using the following method:

Calculation of Free Cash Flow formula

Where:

FCF = Free Cash Flow

EBIT = the Operating Profit

T = the Tax Rate

Dep = the Depreciation Expense

CapEx = the Capital Expenditure

NWC = the Change in the Net Working Capital

The Intrinsic Value of a firm is the sum of the present value of all future cash flows so it can be estimated as follows, assuming we are looking forward for 5 years:

Calculation of value formula

Where,

FCF = Free Cash Flow

D = Discount Rate

TV = Terminal Value

Calculation of terminal value formula

Where:

G = Long-Term Growth Rate

In order to estimate the discount rate, investors usually use the Weighted Average Cost of the Capital method. The weighted average cost of capital is the average cost of sourcing funds for all companies including both equity and debt. The WACC is calculated as follows

Calculation of WACC formula

Where:

E = Equity

D = Debt

Ce = Cost of Equity

Cd = Cost of Debt

T = Tax Rate

Quite straightforward. Just kidding 😀. But since you are still here, let’s work out an example, on AMD stock.

First, we estimate the cost of equity as 10.58% and the cost of debt as 5%. Looking at the company’s balance sheet, AMD has a market value of equity of $133.69 Billion and a Market Value of Debt of $700 million. AMD’s tax rate is 21%. Using the inputs, the WACC of the firm is estimated to be 10.72%.

From the company’s financial statements, we can find the inputs to estimate the free cash flow. AMD’s Operating Profit is estimated as $3.047 Billion, the tax rate is 21%, Depreciation is $430 million, Change in Net Working Capital is -$459 million and Capital Expenditure is -$289 million. Based on this the FCF is calculated as follows

= 3.969 *(1–0.21) + 0.43–0.289–0.459

= $2.817 Billion

If we assume the firm’s free cash flows grow at a steady rate of 8% per year, the terminal value of the firm can be calculated as follows

= 2.817 * (1+ 0.08)/(0.1072–0.08)

= 3.042/0.0272

= $111.871 Billion

Thus the enterprise value of AMD is calculated as $111.87 Billion. To find the Equity value of the firm, we need to apply the following formula

Equity Value = Enterprise Value + Cash — Debt

= 111.87 + 3.61–0.7

= $114.78 Billion

On 13th January 2022, AMD had 1.21 Billion shares outstanding. Based on this, the fair value per share is estimated to be $94.85 per share. AMD Stock is currently trading at $116 at the last close, implying that the stock is overvalued.

I am sure, you won’t be able to apply this method just after reading this article, but at least you got an idea.

As you probably can imagine, many investors find this method complicated and partially subjective because of the many approximations and assumptions that one shall do.

Hope this was useful for you! Please note that the above content is not investment advice and shall be considered only for informative purposes.

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