02) Stock Picking Strategies: Fundamental Analysis

by · October 16, 2010

When someone says “that company has strong fundamentals”, what does this mean?  This phrase is so overused in the world of finance nowadays but few people actually know what it means.  So let’s find out what fundamentals are, why they are analyzed (by fundamental analysis) and how they can be good basis when picking good companies to invest in.

The Theory

If you want to find out whether or not that stock is a good buy, you simply analyze a company’s fundamentals by finding the stock’s intrinsic value.  How much do you really think the stock is actually worth compared to how much its market value is?  If your estimated value is greater than the market value, then it would make sense to buy that stock.

There are a number of ways of computing for a company’s intrinsic value.  Basically, you just add up a company’s future profits and discount this to the time value of money.  How much do you think $1 is worth today compared to the $1 you receive next year?

We equate intrinsic value to future profits because a business provides value to its owners.  For example, you own a small business.  Its worth to you is the money you can take from it year after year once you have deducted expenses.  The fundamentals of a business is profits – revenue less expense. This is where we get the intrinsic value of a business.

Greater Fool Theory

Now that we know what intrinsic value is, you might be asking why the stock market is so volatile.  Why would stock prices fluctuate if a company’s intrinsic value does not fluctuate?  This is called the Greater Fool Theory and one of its assumptions is that people are rational, but who would buy stock in a company greater than its market value?

Fact is people do not see stocks as discounted cash flows but as a means of trading.  Who cares how much a stock is actually worth if there’s somebody –a.k.a. the investor or in this case, the fool –  who’s willing to buy it at a much greater price than the one you originally paid for?   The basics of investing in the stock market lies speculating how much profit you can gain from the sale of a stock not on a company’s intrinsic value.

There has been great debate as to which is the better way of picking stocks:  following the fundamentals or observing the trends.  Investors who go with the trend and observe its tendencies rely on technical analysis to guide them on their stock picking while fundamental investors rely on speculation.  So, which is the better technique?  The answer is neither.  Any stock picking strategy will have its own pros and cons.  In this case, technical analysis is generally thought of as a short term strategy while fundamental analysis is for long term goals.

Putting Theory to Practice

As mentioned above, investors need to discount cash flows to predict the future intrinsic value of a company.  Doing this in theory is easy but doing it in actual practice is hard.  There are a lot of factors that can affect a company in the future.  How do you predict profit ten years from now considering how hard it is to predict profits this year?  What if the company closes?  What if it is sold?  All of these uncertainties have given rise to a number of models in predicting a company’s intrinsic value.  But not matter how “perfect” a model may seem, they are still vulnerable to the future’s uncertainty.

When you predict this far into the future, problem arises with how to account for the different rates a company grows as each year passes.  This is why this table has two parts.  The first part is for determining the discounted future cash flows of a company over the next five years while the second table computes for the “residual value” or the sum of the future cash flows from year 6 to 10.

For this example, it is assumed that the company grows by 15% for the first five years and then by 5% for the remaining five.  In order to determine the present value (PV), the cash flow of the first five years is added together and discounted to year zero or the present.  After the PV for the first 5 years is calculated we move to part two or determining the company’s cash flow for the remaining 5 years where growth is projected at 5%.  To get the intrinsic value of a company, the cash flows of the company from year five are added together and discounted to year zero.  It is then added to the PV of the cash flow values of years one through five.  If the estimate is higher than the current market value of the company, then it may be a good buy.

Below are the notes for the above model:

1.    Prior-year cash flow – This is amount is theoretical. It is the total profits that the shareholders could get from the company in the previous year.

2.    Growth rate – The rate in which the earnings is expected to grow over the next five years.

3.    Cash flow – If all the company’s earnings were distributed to the shareholders, this would be the theoretical amount they would get.

4.    Discount factor – The factor used to determine the present value (PV) of the cash flow.

5.    Discount per year – This is computed as cash flow multiplied by the discount factor.

6.    Cash flow in year five – The projected amount the company could distribute to the shareholders on the fifth year.

7.    Growth rate – The growth rate starting on the sixth year and onwards.

8.    Cash flow in year six – The projected amount the company could distribute to the shareholders in the sixth year.

9.    Capitalization Rate – This is the denominator for the discount rate in the formula for a constantly growing perpetuity.

10.  Value at the end of year five – Value of the company in five years.

11.  Discount factor at the end of year five – The discount factor that converts the value of the company on the fifth year into the present value.

12.  PV of residual value – The present value of the firm no the fifth year.

What we have is a general view of cash flow compromises and sadly, there is no easy of measuring it.   A company’s cash flow to its shareholders is paid through dividends.  The Dividend Discount Model values a company’s future dividends. However, not all companies pay dividends and there are even some who do not pay dividends at all.  When this happens valuation can be done by analyzing net income, free cash flow or EBITDA and other financial measures.  They all have their advantages and disadvantages. The point is that no matter which method is used, the theory in finding the intrinsic value is the all the same.

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