Fundamental analysis is all about intelligent and informed forecast in an attempt to establish an intrinsic value that corrects for that vital information that is missing from the financial statement. Business valuation and financial analysis are incomplete without proper and logically sound fundamental analysis.
Traditional methods of valuation like; method of comparables, screening analysis, and assets based model of business valuation all have one thing in common; they do not involve forecasting.
Share prices are based on the future payoffs that the company is expected to deliver, so one cannot avoid forecasting payoffs if one is to do a thorough job in valuing a shares or a business. This article is written to serve as a guide to making fundamental analysis. Before delving into the discussion of fundamental analysis process, it will be wise to give brief description of the traditional business valuation models mentioned earlier.
BUSINESS VALUATION MODELS THAT DOES NOT INVOLVE FORECASTING
There basically three broad business valuation models that does not require the analyst to make forecast. All that the financial analyst needs to do is fall back to accounting information already contained in the financial statements to make investment decision. They are as follows;
- 1. METHOD OF COMPARABLES: this method of valuation is based on price multiples (i.e., the current stock price divided by any of the following; earnings, book value, sales, etc) that are observed in similar firms. There are however some practical problems associated with implementing methods of comparable which includes; (a) identifying comparables with the same operating characteristic is very difficult. One cannot find two companies that are exactly the same in all respect. One can argue that increasing the number of comparables will neutralise the error but, this makes the exercise more homogenous, (b) different comparables gives different valuations, and (c) negative denominators can occur.
- 2. SCREENING METHODS: this is a method of valuation that believes that underpriced and overpriced stocks can be identified on the basis of their relative multiples. People that employ this strategy in valuing stock buys stocks/ shares that have low PE ratio and sells shares with high PE ratios for example.
- 3. ASSET BASED METHOD OF BUSINESS VALUATION: here, all that the equity analyst does is to identify and sum the value of a company’s assets. From the total value of the firm as represented by the assets, the market value of the firms total debt will be deducted, the residual balance will be seen as the value of the firm. This method also has some worth noting drawbacks. The shortcomings of this method are: (a) market value may not be readily available for those assets that are traded often, (b) market values when available might not give the true value of assets, (c) the value of the summation of assets will be hard to determine even in cases where the analyst manages to get the market value of the assets, (d) how do one identify intangible assets not included in the statement of financial position (balance sheet)?, etc.
PROCESS OF FUNDAMENTAL ANALYSIS
The process of fundamental analysis is a five-step process. The essence of this fundamental analysis process is to determine a value upon which to base our investment strategies and plan.
The value derived from fundamental analysis is compared with the cost of investment. The cost of investment for share price is the market price of shares- if from our analysis we get a value higher that the current market price of shares, the natural thing for us to do is to buy the stock as it is good investment that meets the investment criterion of having a non-zero NPV. If on the other hand we arrive at a value lower than the market price of the share, we simply sell the share and pocket the profit for subsequent re-investment.
If the value calculated is close to or equal to the prevailing market value of the stock, we simply hold the share! i.e. do not buy and do not sell pending the outcome of our next fundamental analysis. The cost of investing / price of investing to an inside investor is the cost of investment, i.e. the cash out flow that the business will experience as a result of the investment decision.
FIVE STAGES OR STEPS OF FUNDAMENTAL ANALYSIS
The fact that fundamental analysis is a process makes it important that different stages of the process be identified so as to give the analyst clear indication of where in the steps he or she in. This section of the article is devoted to explain the steps involved in fundamental analysis in a simple manner:
- 1. KNOWING THE BUSINESS / STRATEGY ANALYSIS: no meaningful fundamental analysis can be based on “nothingness.” It has to be based on a foundation- not just any kind of foundation but, a solid foundation. That solid foundation can only be built through acquisition of industry and business knowledge and proper analysis of a company’s strategy. Understanding the business is a prerequisite to valuing the business. An important question to always ask while doing this is; “does the firm’s strategy add value?” The concern of the outside analyst is to value a given strategy. This he or she does by gaining knowledge of the; products of the target company, knowledge base of the target firm, the competition of the target firm, the regulatory framework of the industry where our target operates, and the management of the firm. These analyses are done in the broad context of economic, political, and environmental macro variables that influences the company’s strategies- accepting sounding strategies and discarding bad ones.
- 2. ANALYSIS INFORMATION: armed with working knowledge of a business, an analyst stands in a better position to analyse and scrutinize information that relates to the target firm. This information can be found both in the financial statements and outside the financial statements. The problem that many analysts face in this step of fundamental analysis is that- it is very difficult to filter out noise from information. Hard information contained in the company’s financial statements is polluted by many factors which include; fraudulent financial reporting, loopholes in accounting standards, trade-offs between qualitative characteristics of financial information, etc. As an analyst, part of your duty is to filter out these noises, this you can do by making reference to the notes to the accounts and make adjustments to questionable treatment of items- auditor’s report is also a very good place to go for hints.
- 3. MAKING FORECASTS: forecasting is a difficult task that must be made if any form of fundamental analysis is to be made. The most difficult aspect of this step is to identify the payoffs, i.e. do we have to forecast cash flows, book values, dividend, ebit, or return on equity. The fact of the matter is that one sees all of these numbers in analysts’ research report.
- 4. TRANSLATING YOUR FORECASTS INTO VALUATION: leaving the forecast just the way it is will not make economic sense. Since figures are expected to be received in the future, investors will not be comfortable with future amount- they want to know what that figure is now! A way of solving this problem is to convert the forecast into valuation. The process of converting this forecast into valuation is what is known as discounting. That is, saying what those future values are worth now in order to take care of the time value of money. It is safe to say at this point that valuation helps reduce all the future payoffs into one number! The risk element of investment is equally taken into consideration. Note that these payoffs can also be capitalised.
- 5. INVESTMENT DECISION: this is where the decision of whether to invest or not to invest is made. Comparison is made between the current market value of shares and the valuation produced from the valuation model used to value the company/ shares. This part of fundamental analysis is sometimes referred to as investment appraisal.
It is clear from the above discussion that fundamental analysis is a process that translates ones knowledge of a business together with other information into valuation and strategy analysis of a business. I encourage you to read some of the books displayed below for further and broader knowledge of business valuation and fundamental analysis.
To your success as an equity analyst!
Muhindo Isaac, Kampala says
Good work. I benefited from your material. Thanks