Fundamental analysis is a method for evaluating a security which involves the use of financial statements to study factors that are directly related to it. When performing fundamental analysis, you are trying to find out the company’s intrinsic value or what it’s actually worth as opposed to just looking at its market price. The idea behind finding a company’s intrinsic value is simple. You add all future profits together then discount it to account for the time value of money. Basically if your analysis suggests that the stock is worth more than its market price, it would be logical to buy it.
Like most things, finding the intrinsic value of a company is better said than done. That being said, below is a model I made to show you what it would look like to try and figure out the intrinsic value of a company.
Growth rate – The rate at which owner’s earnings are expected to grow for the next five years.
Cash flow – The theoretical amount that shareholders would get if all the company’s earnings, or profits, were distributed to them.
Discount factor – The number that brings the future cash flows back to year zero. In other words, the factor used to determine the cash flows’ present value (PV).
Cash flow in year 5 years – The amount the company could distribute to shareholders in year five.
Growth rate – The growth rate into perpetuity.
Cash flow in 6 years – The amount available in 6 years to distribute to shareholders.
Capitalization Rate – The discount rate (the denominator) in the formula for perpetuity
Value at the end of 5 years – The value of the company in 5 years.
Discount factor at end of 6 years – The discount factor that converts the value of the firm in year five into the present value.
PV – The present value of the company in 5 years
Many issues can come up while doing fundamental analysis. One is the possibility of the company stopping all operations. Another one of the issues would be predicting future cash flows for the next x amount of years. It is difficult enough to predict one year, let alone several. For purposes of keeping the model simple, I made it constant. If you ever create your own model, you could always just change it to whatever growth rate you think is suitable. These uncertainties can never be escaped.
This has been a very general example and there are many other ways to evaluate a company’s intrinsic value. Either way, the theme of knowing actual worth as opposed to just looking at its market price remains constant.
There are some criticisms of fundamental analysis. These mostly come from investors who use technical analysis and from people who believe in the efficient market hypothesis.
Technical investors don’t care much for the intrinsic value of a company. They believe that fundamental analysis is insufficient because it can’t explain the constant price fluctuations in the market. They do have a point. Why would the price keep fluctuating if the intrinsic value isn’t constantly changing as well? This is why they prefer to analyze trends. They don’t care if the intrinsic value is lower than the market value as long as they’ll be able to sell the stock to another investor for higher than what they paid for. Anyways, fundamental analysis is seen as a long-term strategy while technical analysis is used for short term-investing. Neither is better. They’re just different.
As for the believers of the efficient market hypothesis, they just believe that it is impossible to beat the market by huge margins in the long run. The idea behind that is that whether you use fundamental or technical analysis, opportunities for huge returns will be whittled down almost immediately by the market’s many participants.
