Use Fundamental Analysis Techniques to Estimate the true "Value" of an Investment


Fundamental analysis techniques refer to calculations that try to estimate the "true" value of an investment instrument using publicly available financial data.

In addition, fundamental analysis techniques can take into account macroeconomic factors such as global, national, and industrial outlooks, interest rates, and inflation.

Warren Buffet's success with this type of analysis is well-publicized, and he is considered to be one of, if not the best fundamental investors.

What are Fundamental Analysis Techniques?


The goal is to compare the "true" value of an investment with the current market value, and find investments that are mispriced.

When the "true" value is lower than the current market price, an investment is "overvalued".

This means meaning that price is too high, and investors should consider selling (or at least not buying).

If the "true" value is higher than the current market price, an investor would say the investment was "undervalued", which is a buying opportunity.

Key Ratios

Financial

  • Sales
  • EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization)
  • Net Income
  • EPS
  • Dividend/Share
  • Debt/Equity
Valuation
  • Price/Earnings (P/E Ratio)
  • Price/Book Value
  • Price/Sales
  • Price/Cashflow
Profitability
  • Return on Equity (ROE)
  • Return on Assets (ROA)
  • Operating Margin
  • Net Margin

Why Use Fundamental Analysis Techniques?


Advantages
  • Markets, over a long period of time, tend to be driven by fundamental factors, making fundamental analysis a useful tool for assessing potential, long-term market conditions
  • Generally Accepted Accounting Practices (GAAP) allow investors to calculate and compare true value and financial information for different companies
Disadvantages
  • Markets do not always behave in agreement with fundamental information
    • Companies with superior fundamentals can fall in price and lose money for investors during a market correction or recession

  • Standard accounting practices are not set in stone, and do have some flexibility
    • Companies can use "earnings management" and/or report "pro forma earnings" to improve their financial picture

  • Standard accounting practices are not guarantees
    • Companies still manipulate their financial data ("cook the books")
    • Enron and WorldCom are well known examples

Example of Fundamental Analysis


The price-to-earnings ratio (P/E Ratio) is one common data point used in fundamental analysis.

You will need the current market price for the investment instrument you're considering, as well as the earnings per share (EPS) of that same instrument.

Dividing the current price by the earnings per share will give you the P/E Ratio. For example, go to the Yahoo! Finance (Click here to open Yahoo! Finance in a new window) or Marketwatch (Click here to open Marketwatch in a new window) webpages and look up a quote for Microsoft (MSFT).

These sites have a lot of information in the "profile" or "key statistics" pages.

The pages have done some of the heavy lifting for you, but most of the fundamental analysis techniques listed on this page will require that you look at the companies financial statements.

Assume that MSFT stock is currently trading at $25.50, with an EPS of $1.62 / share.

As stated above, the P/E Ratio is calculated by dividing the price per share (25.5) by the earnings per share (1.62). This gives you a P/E Ratio of ~15.74.

On a side note, you may have noticed the abbreviation "TTM" next to the EPS (and the P/E Ratio the sites calculate for you). TTM stands for "trailing twelve months".

This means that you are using the earnings from the past twelve months (verses forward looking earnings).

Now its time to make some comparisons. Lets assume that Microsoft is part of an industry group that has an average P/E ratio of 20.

So MSFT has a lower P/E ratio than its industry group, meaning that it is undervalued when compared to its industry group.

That said, you need to take into account all the different facts that affect price and earnings before truly deciding whether the P/E ratio is accurate. This is true for all fundamental analysis techniques.



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