Many people check the food labels of the items they buy in the grocery store. Labels can help give them an indication of what they buy to eat is good for them.
Similarly, publicly listed companies have the equivalent of a label that investors can use to check the soundness of companies. It comes in the form of fundamental analysis.
The information provided from fundamental analysis is considerably more complex than food labels. But it is available to help investors value companies correctly.
Fundamental analysis attempts to derive a company’s “intrinsic” value. Investors examine the financial position of companies. They also evaluate current economic conditions for these businesses.
Some investors use a rigorous approach to fundamental analysis. They examine the cost of capital of a firm and discount the cash flows associated with those costs.
The results of the calculation produce what many investors believe is a company’s intrinsic value.
The biggest drawback to this approach, known as the discounted cash flows, is the investor’s assumptions. The model is sensitive to these assumptions. Likely, two investors may not arrive at the same conclusions when using these methods.
Another approach is to use comparables of other companies in an industry. Another name for this is the multiples approach. This approach is similar to valuing houses in a neighborhood.
It works by finding several companies in the same industry and applying the average of the industry multiples multiplied by a value driver of the target company.
Investors can use measures like the price-to-earnings ratio or the price-to-book ratio for the multiples.
Refining the approach
Some investors refine this methodology even further by attempting to find one company closely related to the target company. Then, they multiply a multiple such as price-to-earnings to that comparable company’s earnings or other measures that determine value.
The comparables method relies on the law of one price, which states that two companies with the same risk profile and earnings will have the same price.
If the prices deviate at any point arbitrageurs will step in, causing the prices to match.
A challenge with this approach is finding companies that are a close match to the target company. Large corporations have multiple business units. They also own subsidiaries.
For example, Microsoft sells operating systems, but it also creates productivity software. It is involved with cloud computing services, and currently, own career site LinkedIn. Microsoft is not alone in the wide number of different companies and business functions it manages.
Some investors use a Goldilock’s approach to determine if stocks are overvalued, undervalued or properly valued. They set a threshold that determines the status of the valuation.
For instance, some investors consider any stock with a price-to-earnings ratio over 20 to be overvalued. Investors are free to use a variety of methods to determine the proper thresholds, including guessing.
Keeping valuation simple
Perhaps the easiest valuation approach is to compare the multiples (such as the price-to-earnings ratio) against a company’s own historical multiple. For instance, if the average of the past 10 years price-to-earnings ratio is 15, a current ratio of 12 may lead investors to believe the stock is cheap.
You may choose to implement several of the described approaches to determine the value of a stock. You could calculate each of them and take the average of the results.
Investors should also consider the industry of any company they are analyzing. Automobile companies, such as General Motors, were the darlings of Wall Street for several decades.
Today, many investors shy away from companies in this industry for a variety of reasons.
There is quite a bit more to fundamental analysis than the few concepts presented here. New concepts are added and old ones are redefined.
Over time, investors find the measures that work for their investment goals. They take stock of the effectiveness of the measures and make adjustments as they see fit.