Significance Of Fundamental Analysis

  • Feb 09, 2019 AEDT
  • Team Kalkine
Significance Of Fundamental Analysis

Fundamental analysis is a method of analysing the financial, economic, and other quantitative and qualitative factors for computing the value of the company and its stock. Before calculating the intrinsic value, the analysts must study all the macroeconomic factors such as the economy, industry conditions, etc. as well as microeconomic factors such as company management and financial conditions, with a purpose of producing a quantitative value that an investor can compare with the security's current market price. This helps in identifying whether the security is undervalued (if the intrinsic value is higher than the market price) or overvalued (if the intrinsic value is lower than the market price). It usually helps in determining the health of a company and further identifying a multi-bagger stock.

Also it is useful to know the logic behind selecting the companies rather than just investing in them without knowing anything about the company or investing in a hurdle. Below are a few methodologies or key aspects which one should consider while doing the analysis:

  • Understand the company:

The first thing is to understand the company in which a person is investing as it helps in identifying whether it is taking right decisions towards the business future goal or not and how is the company performing and then ultimately deciding whether to hold or sell the stock.

While understanding the company, the person should study the products & vision of the company and if it is attractive, then move ahead to investigate more, otherwise ignore the company.

  •  Study the financial statements of the company:

After understanding the company and finding it to be attractive, the second step is to study the financial statements of the company like income statement, balance sheet, and cash flow statement.

A person must analyse the revenue drivers of the company and check the compounded annual growth rate (CAGR) for sales, EBITDA, net profit increase over the last 5 years and check the margins. However, other financials like Operating cost, revenue, expenses etc. are also important.

Further, there are a few industry-specific metrics such as Funds from Operations in case of a Real estate, Common Equity Tier 1 Capital Ratio in case of the banking industry, etc.

The person should choose companies that have a good asset built up. Usually, a financially stable company have huge fixed assets in the form of plant and machinery or land, and if the company is an investment and holding company then a huge portfolio of investment. And Net Current Assets should also be huge as huge cash balance might indicate solid financial standing.

Huge Reserves enables the company either to carry out the expansion with its internal accrual only & if no expansion plan in the near future, then it can give a bonus in the form of dividends.

A company which is debt free or has negligible debt status has the advantage of generating good residual profit for its shareholders as there is no debt servicing burden.

  • Evaluating Financial Ratios and multiples:

A person should check the ratios as well as multiples that are relevant to the industry.

If Equity is low, then returns to ShareHolders would be high.

Consistently high Profit After Tax enables the company to generate good reserves for Share Holders. High promoter shareholding means promoters have more confidence in their own business than outside opportunities & usually such company has 70 -75% promoter shareholdings. Higher EPS is also possible if equity is less and profit earned is very high. If a company has a low P/E ratio than the industry P/E ratio, it indicates the stock to be undervalued.

For the multiples:

A person should use forward-looking multiples based on forecast and if no reliable estimates are available, then go for historical data and take the latest information possible while eliminating one-time events. Forward-looking multiples help in predicting more accurate values.

A person should use enterprise-value multiples as P/E multiples have significant flaws like they are affected by the capital structure and they are based on earnings, which include items like write-offs, restructuring charges and other one-time events. Enterprise value (EV) to EBITDA is an alternative to the P/E ratio as there are fewer chances of manipulation by changes in capital structure. Since EBITDA is the profit available to investors and EV includes both debt and equity, therefore, any change in capital structure will have no effect. Similarly, if the nature of the business is capital intensive, this multiple take that also into account by excluding depreciation amount.

PEG ratio is another alternative as it allows the expected level of growth to vary across companies calculated by dividing the P/E ratio of the company with its earnings growth rate. It also has drawbacks like there is no standard time frame to measure the expected growth and it assumes that no growth implies zero value.

  •  Find the company’s competitors:

The last step is to find and analyse the peers of a company before investing. The person should try to find out what the selected company is doing which can differentiate it from its competitors such as upcoming projects, unique selling point (USP), future prospects, new plant etc.

 Calculation of Intrinsic value:

To calculate the intrinsic value of the company, a person can use an absolute valuation model or relative valuation model.

Under the absolute valuation method, discounted cash flows (DCF) analysis is performed to calculate the company’s worth/value. Under the DCF model, the company’s future cash flows are estimated first, and then they are discounted to the present value at a predetermined discount rate to calculate the absolute value of the company. The discount rate is a rate of return, which is generally used to discount a firm’s future expected cash returns to the present expected value. The analyst must use the relevant discount rate to calculate the present value, for example, cost of equity is used while using free cash flow to equity, the weighted average cost of capital (WACC) is used in case of free cash flow to the firm. By comparing this value with the actual prevailing price in the market, the analyst can find whether it is currently under or overvalued.

Methods used under the DCF model includes the discounted FCF method which discounts free cash flow (FCF), the dividend discount model (DDM) which discounts dividends, discounted residual income method, and discounted asset model.

Under the relative valuation model, the analyst compares and analyses the financial worth of the company on the basis of its competitors or industry peers. Relative valuation models try to determine a company's intrinsic value using multiples such as averages, ratios and benchmarks. There are many approaches for relative valuation such as comparable company approach, precedent transaction approach etc.

With relative valuation, you get a specific multiple, say EBITDA, and it is compared with the industry average/median. For example, a company is expected to generate an EBITDA of A$ 100 million over the next 1 year, and the industry’s median EV/EBITDA is 20x, then the company should be worth around a$2 billion, keeping other things constant. It does not consider cash flow, growth, margins, etc.


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