The ultimate Q&A to Fundamental Analysis 101
Investing tips 04: I first published this post in Mac 2021 based on the investing advice that has been collated from my Quora responses. It has now been updated to include specific answers to what are fundamental analysis, company analysis and valuation. Revision date: 28 Jul 2021
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| “No wise pilot, no matter how great his talent and experience, fails to use his checklist.” Charlie Munger |
There are two main ways to invest in the stock market:
- Buy and sell pieces of paper. If you follow this approach, you would focus on analyzing stock prices and transaction volume. This analytical approach is called technical analysis.
- Buy and sell part ownership of companies. If you follow this approach, your focus is on analyzing the business prospects of companies. You then determine the value of the business based on its outlook. This analytical process is known as fundamental analysis.
There are both quantitative and qualitative aspects when undertaking a fundamental analysis.
Quantitative analysis is about numbers. They are the measurable characteristics of a business. That's why the biggest source of quantitative data is financial statements. Revenue, profit, assets, and more can be measured with great precision.
The qualitative analysis is less tangible. It might include assessing the quality of a company's management, its business strategy, brand and proprietary technology.
Neither qualitative nor quantitative analysis is inherently better. Many analysts consider them together.
This post is part of a series meant for newbies. I focused on answering the questions from the view of a bottom-up, stock-picking, long-term value investor.
I am coming from the perspective that you are interested to learn how to invest based on fundamentals. This requires you to analyze and value companies.
If you don't want to do this, but still want to invest based on fundamentals, there are many third-party advisers who can do this for you. A good example is Seeking Alpha.* Click the link for some free stock advice. If you subscribe to their services, you can tap into their business analysis and valuation.
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Contents
1. What is Fundamental Analysis
2. Company Analysis
3. Valuation
1. What is fundamental analysis
Investopedia defined fundamental analysis as a method of measuring a security’s intrinsic value by examining related economic and financial factors. The goal is to arrive at a number that an investor can compare with a security current price in order to see whether it is undervalued or overvalued.
Fundamental analysis is different from technical analysis. In technical analysis, you forecast the direction of prices through the analysis of historical market data such as price and volume.
Fundamental analysis is not concerned about the direction of the stock price.
There are two aspects of fundamental analysis:
- How to analyze a company. You look through the annual reports and the financial statements to help you in evaluating the performance of the company. The goal is to select good stocks for your portfolio.
- How to value a company. You estimate what a company is worth ie its intrinsic value. From a value investor’s perspective, you now have a basis to determine the margin of safety.
All valuations are based on assumptions and one of the objectives of company analysis is to ensure that the assumptions you use in the valuation are grounded in reality.
There are various tools and techniques that can be used for fundamental analysis, but they have been categorized into two types:
- Top-down analysis. This takes a broader view of the economy, starting with the entire market before narrowing down into a sector, industry and finally a specific company.
- Bottom-up analysis. This starts with a specific stock and widens out to consider all the factors that impact its prospects.
1.1. What book would you recommend for fundamental analysis?
When you talk about fundamental analysis, there are 2 different things involved - how to analyze businesses and how to value them. They require 2 different skillsets.
The former is trying to assess the prospects of the business taking into consideration its business strategy, its track record and management capabilities, etc. This is like a mini-MBA analysis but from an investors’ perspective.
The second is about how to fit the info from the former in the valuation methodology so that the valuation is not merely some number crunching exercise.
Furthermore, the majority of the info required for these comes from the company’s accounts. You need to be able to understand the various financial statements. And then you have to fit risk mitigation into the process.
I have not come across a book that does all the above well. I have written articles about how to find free online resources for all of them. You need more than one book, podcast, or video.
2. Company analysis
Company analysis involves collecting information about a company in order to determine its business prospects. Information here includes those related to the company’s profile, products and services as well as profitability.
It covers basic information about the company’s mission statement, its goals and values. During the process of company analysis, you also consider the company’s history, its track record and risks.
As an investor, there are 2 goals in the company analysis:
- To determine whether it is a good company from a fundamental perspective. In order words, whether it has good prospects and is financially sound.
- To ensure that the assumptions you use in the valuation are based on what you have found from the company analysis. In other words, you want realistic assumptions.
2.1. What are good ways to perform a qualitative analysis of a company?
Before you perform any qualitative analysis, you have first to figure out the purpose of the analysis. Analyzing companies to determine whether it is a good stock to invest in is different from analyzing it to determine its creditworthiness.
Analyzing companies for takeover targets also look at different things. It also differs if you are an insider trying to figure out the business direction of the company.
If you are extracting information to get inputs for valuing the company, then not only do you have to cover the financials, but you also have to read the Chairman Statement and Management Discussions.
I look at the past 12 years of annual reports to assess:
- How the company got to where it is today from a qualitative and quantitative perspective.
- Whether management has done a good job.
- The business direction of the company.
Investing is about putting monies into companies based on your assessment of their prospects and the price vs intrinsic value position.
2.2. Name at least 3 ways that stockholders can take to ensure that management and stockholders’ interests are aligned.
The goal is to ensure that management does not do things that benefit them rather than the company or shareholders eg giving themselves bonuses even though the company is making a loss, or using company assets for their benefits.
Secondly, business performance needs a long-term perspective so management does not forgo investments that only show results after several years.
How can you achieve this?
- The best way is for the major shareholders to be part of management. This is common in family-controlled companies.
- The second is to tie performance bonuses to long-term returns on capital so that there is a deduction for losses. Performance payment is made later and even after he has retired to send the message that the company wants long-term results.
2.3. How would you use Philip Fisher's Scuttlebutt approach as an individual investor?
The goal of the scuttlebutt approach is to get a better understanding of a particular industry/company.
So, if you are already knowledgeable about a particular industry eg you spent many decades working in the industry, then the scuttlebutt may not add any value.
For an individual investor, I would think that your first step is to read the past decade of the company’s annual reports. And if you are not familiar with the industry, there are lots of info that you can get online.
I am sure these would be a more cost and time-effective way to get a good understanding than the Fisher scuttlebutt approach involving fieldwork.
Think in terms of the cost-benefit. Besides, unless you are a trained investigator, you may not be seeing the correct things with fieldwork.
The moral of the story - you are better off with desk research as an individual investor.
2.4. After a stock split, the stock price gets adjusted. But do the fundamentals of the stock also get adjusted?
Imagine you have a cake. You were looking forward to eating it all on your own. But your sister then cut it into 6 slices first. But you still managed to eat it all. Did you get to eat more or eat less because it is cut?
That is what stock split is equivalent to. It is still one cake whether it is sliced into 6 pieces, or 4 pieces or remains uncut.
However, as the stock market is sentiment-driven, people do not think like that. Sometimes it is psychological. Sometimes it is a practical issue.
Imagine a stock that is priced at $ 1000 per share. Assume that its intrinsic value is also $1000 per share. It may be too expensive for some to buy. Now it is split 1000 times so that now the intrinsic value is $1 per share. Because it is more affordable and or there are more shares available, more may buy and the demand drives the price up even though the intrinsic value remains the same.
You can imagine the sentiment going the other way. People may think that the stock split is because the Board is trying to boost the share price and interpret it as a sign that the company is in trouble. People begin to sell and supply exceeds demand causing the price to fall even though the intrinsic value remains the same.
The moral of the story - stock split does not affect the fundamentals and the intrinsic values get adjusted to reflect the new number of shares. But prices do change.
3. Valuation
There are 3 general ways to value companies:
- Relative valuation.
- Asset-based valuation.
- Earnings-based valuation.
The simple way to understand them is to use the analogy of how properties are valued.
Relative valuation is valuing your house based on the comparable value of houses in your neighbourhood. You might scale it to account for some of the differences in the properties.
For example, if your neighbour’s house is worth $ X on 2,000 sq ft of land, you may conclude that since your house is on 3,000 sq ft of land, it is worth $ 1.5 X.
When it comes to valuing companies, there are several common bases for comparison such as earnings, book value or revenue. And a common way to account for the different size of the companies is to consider the metrics on a per share basis.
For example, if comparable companies are trading at 10 times their earnings per share, your company should also be worth 10 times earnings per share. This is valuing the company based on the Price Earning multiple.
Asset-based valuation is valuing your house based on what it cost to buy the land and build the house. You might use the historical cost to serve as the floor value or you might use the current cost.
There are several ways to determine the value of companies when using this approach. For example, we could use the book values, the revised net asset values, and even the reproduction values.
Earnings-based value for your house is the present value of all the net rental income over its life. You will of course have to decide on the appropriate discount rate to use in order to compute the total present value.
In the context of valuing companies, we have the discounted cash flow method. The variables to consider are then what to use as the cash flow, which discount rate to use, and how to account for the life of the business.
I do not consider relative valuation an intrinsic valuation approach.
3.1. What are the best books on learning how to value a company's stock?
There are two issues in valuation:
- The mechanics or the “formula” part of the valuation.
- The assumptions and other inputs required for the “formula”.
In this context, there are two skills that you need to develop:
a) How the value companies to cover the first bullet point. This could be asset-based to earnings-based methodologies.
b) How you analyze companies to get realistic info, assumptions, etc as per the second bullet point.
For (a), I would recommend Damodaran’s Investment Valuation and Penman’s Financial Statement Analysis and Security Valuation so that you have two different earnings-based valuation approaches.
Damodaran covers the Free Cash Flow one while Penman coves the Residual Income method. In theory, both of these would give the same answers but in practice, I find that they do differ. I use both to get a better triangulation.
For (b), the “conventional” valuation books don’t do a good job. I am not even sure whether there is one book that covers all that you need. This is basically an MBA course from an investor's perspective.
3.2. Is there a mathematical formula to calculate a stock value - is calculus used?
There are several formulae. The challenge is not finding the formulae. It is whether the assumptions you make in using the formula reflect reality.
If you are valuing stocks, the first step is to analyze the business so that you understand the business prospects, management capabilities, and risks.
These will then guide what you assumed about the cash flows, growth rate, and discount rate.
The challenge in valuation is to ensure that it does not turn out to be a number-crunching exercise. This is where expertise and experience come in.
I have not heard of any company using calculus to make investment decisions. Over the past 30 years, I have been involved at the C suite level in looking at over 30 project investments. The biggest challenge has always been about the market demand. No amount of calculus is going to be helpful.
Projects are long-term investments stretching years and even decades. You are forecasting the future. It is like long-term value investing in the stock market. The only maths you require are multiplication and addition.
3.3. How do I arrive at the correct value of a stock?
There are two views on the value of a stock
- Asset-based that looks at the assets as a store of value.
- Earnings-based that looks at the assets as a creator of value.
Both may not give the same answers. Even within each method, different people will come to different answers due to the assumptions made. There is no “correct” value.
There is only the “intrinsic value” that has been derived based on your outlook and assumptions used in your computation.
Having said that, those in the value investing school would say that a stock is over or undervalued by comparing its price to the computed intrinsic value.
3.4. Why can the combined equity of a group of companies be less than the parent company’s equity, even after subtracting the non-controlling interest?
Imagine this scenario:
- You have a parent company that is listed with several listed subsidiaries (collectively called the Group).
- The parent has its own operations independent of its listed subsidiaries.
- The subsidiaries' operations are also independent of each other.
- At the parent level, the performances of the various subsidiaries are reported as separate segments performance
You can value the Group in 2 ways:
a) The look thru method - one is to look at the value of the various operating subsidiaries and the parent separately. You can do this because listed companies all have their financials publicly available.
The value of the Group is then the sum of all the various weighted subsidiaries' valuations plus that for the parents’ operations.
If the parent owns say only 60% of each subsidiary, you would only account for 60% of the subsidiaries' value when summing them up ie the weights are 60%.
Note that the non-controlling interest is automatically taken care of by the 60% weights.
b) The overall method. Here you value the Group as a whole and then subtract the non-controlling interests to get the value of the Group.
In theory, both methods should give you the same answer. In practice, you don't get the same answer because we don't generally have the same information detail at the individual subsidiaries level compared to the Group level.
For example, at the Group level, the performance of some of the subsidiaries could be grouped together into segments. So, you only have segment performance.
To come back to your question. If the parent doesn't really have any business operations eg it is merely head office expenses, then when you sum up using method (a), you will find that the Group value is less than the sum of the individual subsidiaries.
If you do a valuation via (b), your question does not arise.
3.5. How can I tell if a stock is trading below its Fair Market Value?
If you know the fair value, then the answer is obvious. I think your question should be “how can you assess its fair value?”
There are 2 main ways to value stocks - asset-based and earnings-based. Refer to Q8. You need both to triangulate the values.
Once you have the fair value or intrinsic value, you then compare the price with its intrinsic value. I would imagine anything less than 20% to its intrinsic value would provide a good margin of safety ie you can conclude that it is below its Fair Market Value.
3.6. Would you sell your business for book value?
The book value technically represents total assets minus total liabilities ie the net of what has been invested in the company. You can think of this as the net assets.
When it comes to selling the company, there are 2 considerations
- Not all assets are captured in the book value.
- The book value may not capture the earning power.
3.6.1. Not all assets captured
(Excluding any acquisition) accounting practices generally mean that only physical assets are captured in the book value. So your brand value, business relations, business know-how, etc are not reflected in the book value. If these are valuable, then the value of the business is more than just what is captured in the book.
The Book value is an accounting value and may not reflect reality.
Imagine the case where company A acquired another company B for $ 10 million. But it paid a high price in that the tangible assets of B are only $ 1 million. But in the company A books, the full $ 10 million is captured ie $ 9 million is recognized as goodwill. Now suppose that another company wants to acquire A but figure out that the goodwill of B is only $ 3 million. Would you be surprised to find that the selling price of A is less than its Book value?
Consider another case where the company is a property company that owns lots of office buildings. The values of the properties were valued at market price before the Covid pandemic. Now with the work from home trend, the demand for offices will face a long-term decline and in a few years’ time when rentals are renegotiated, they may fall by 20 %. Suppose you want to invest in the company. Would you take the book value or would you discount it?
3.6.2. Earning power
There are two ways to view the net assets of the company:
a) one is as a store of value. This is what the book value represents.
b) the other is as a creator of value ie how will the assets be used.
In a highly competitive environment, the book value should equate to the value of (b). If you have a very strong economic moat, (b) will likely exceed the book value. But if you are deploying the assets in an inefficient manner, (b) may be less than book value
Conclusion? Because of (1) and (2), people generally don't sell below the book value.
But if you have a lousy business that is run inefficiently and there are no future prospects, you may sell it below the book value as eventually, the book value will deteriorate eg impairment.
Unfortunately like all investing issues, there is no straightforward answer. It has to be case-specific.
3.7. My business makes $10,000/month, how much should I sell the business for?
The reality is what you can sell for will depend on 2 important factors - the buyer's expectation and what you can do with the money post-sale.
a) You can, of course, ask for as much as possible. But this will be capped by buyers’ expectations.
b) But what do you want to do with the money after the sale? If you can get better returns from another investment, you may probably want to sell for less.
The amount you will sell for will lie in between (a) and (b).
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