Fundamental analysis is the process of examining a company’s financial statements and health to determine the intrinsic value of its stock. It involves analysing key metrics like revenues, expenses, profits, assets, liabilities, and cash flows. Comparing a stock’s current price to its estimated intrinsic value using fundamental analysis can reveal if it is overvalued, undervalued, or fairly priced.
In this article, we will look at the factors to consider when conducting stock valuation. Knowing the intrinsic value of a stock can allow traders to more accurately predict where the stock price is headed, so they can make more informed decisions when investing in stocks. To learn more, read on.
Disclaimer: Stock trading involves risk, and many retail traders lose money. Though stock valuation can help traders make wiser decisions, it is not a foolproof technique and there is no guarantee of profitability. Traders should ensure they know how the stock market works, understand their risk tolerance, and apply the appropriate risk management strategies to maximise their chances of success.
Review financial statements
The starting point is to gather a company’s income statement, balance sheet, and statement of cash flows for the previous few years. These reveal trends in sales, profits, assets, liabilities, and cash generation over time. Pay attention to consistency and growth rates. Seasonal or one-off impacts should be considered, especially for companies that may be affected.
Analyse Profitability and Income
Key metrics here include gross margins, operating margins, net profit margins, earnings per share (EPS), and return on assets/equity. Strong and stable profits within the industry norm are favourable long-term indicators. Watch for consecutive years of growth over declines.
When analysing long-term performance, remember that changes that persist are more meaningful. This means that it is essential to look at sustained levels of performance over one-off periods. If a company tends to perform well over time with relatively few dips in income, this is a good sign.
Assess Financial Position
Examine assets, liabilities, and the debt/equity ratio on the balance sheet. Consider the quality, liquidity, and turnover rates of assets. High or growing debt levels can be concerning, and they can be indicative of a larger problem that will manifest. Positive shareholders’ equity also signifies a strong financial base, and you should check who the shareholders for the company are and the history of their financial positions.
Additionally, liabilities should primarily fund operations rather than excessive leverage. Liabilities are a company’s obligations that they owe, such as debt from loans. It is preferable for a company to use liabilities to fund its ongoing business operations, rather than relying too heavily on debt to finance growth.
Evaluate Cash Flow
Positive, growing operating and free cash flows indicate the business is generating more cash than it consumes. This provides fuel for reinvestment, acquisitions, debt payments, or distributions to owners. High or volatile cash conversion cycles can be risky.
Analyse Industry and Competition
Understand broader industry trends, regulations, risks, entry barriers, pricing dynamics and competitive forces. Favourable positions in growing, protected industries aid long-term prosperity.
Another thing to note is that excess capacity or commoditization in a sector poses challenges. This means that if there is too much supply in a sector that looks like it may outpace demand, it may not be a good sign for the company’s financial future.
Forecast Future Financials
Project 3-5 years of income statements, balance sheets and cash flows using estimated growth rates for revenues, costs, assets, debt and other factors. Conservative estimates are wise, as there is no way of predicting how the company will perform in future years with the influence of external factors. Compare to management’s guidance if available, which can sometimes be found in public financial reports of companies.
Estimate Intrinsic Value
Common valuation methods include discounted cash flow analysis and calculating price-to-earnings, price-to-book and price-to-sales ratios within historical norms and relative to industry peers. The lower the purchase price compared to estimated intrinsic value, the greater the margin of safety. You should also base your investments on your risk profile and how much you can afford to lose.
Re-assess Regularly
Fundamentals and valuations are not static, so analysis is ongoing. Compare actual performance to forecasts and industry averages every once in a while. You should also adjust projections and price targets accordingly for changing conditions, especially those that greatly impact the economy, such as market crashes, trade agreements and disagreements, and epidemics and pandemics. Do not be afraid to sell if fundamentals or valuations deteriorate significantly versus similarly attractive alternatives.
Final words
Thorough fundamental analysis informs sound buy/sell/hold decisions by assessing a stock’s intrinsic value backed by hard data rather than speculative motives or short-term price movements. It weeds out overvalued companies and identifies underpriced gems with strong balance sheets, profits, and long-term growth potential for savvy investors.
