Fundamental Stock Valuation: Part 1
Fundamental Stock Valuation: Part 1
This article is the beginning of a series on fundamental analysis and its evaluation. First of all, we should highlight the advantages that fundamental analysis gives us:
- Confidence that the company is not at risk of delisting.
- Confidence that the company is growing, which could lead to an increase in the price of its shares.
- Confidence that the company is not a debtor.
So, fundamental analysis is our insurance for the invested capital. When creating an investment portfolio, we can clearly understand the overall prospects of the portfolio and how our stock portfolio can outperform the S&P 500 index. Generating returns higher than the index is called generating alpha.
What fundamental analysis does not give us:
- Understanding where the price will be in a few weeks or even months.
- Understanding how vulnerable the company is to a drop in the S&P 500 index.
In conclusion: without fundamental analysis, it is impossible to invest, as you expose your capital to risk. A company that is in debt can quickly drop in price if it needs to raise new loans, and a company that is not generating profit might even open with a deep gap down after the next financial report.
To begin with, I would like to mention some resources that will help us study this topic:
- http://www.investopedia.com/ — essentially an encyclopedia of finance, containing almost all the information about markets.
- morningstar.com — an excellent site for analyzing fundamental reports, which we will be working with.
The value of a company is formed from 3 main factors:
- Capital
- Debts
- Future profits
For example, if a company has no capital, it will not be able to grow in price until it builds up capital. If the company is facing debts in the foreseeable future that it cannot pay off, it will have to raise loans, which will negatively affect its reputation. If the company is consistently generating profits but a decline is expected in the next two years, it will force many investors to sell the stock, leading to a price drop.
Partially, answers to all three questions can be found in the following 3 reports:
- Income Statement
- Balance Sheet
- Cash Flow
Let’s consider these reports using Macy’s Inc. (M) as an example.
Income Statement – This is the profit and loss statement. It will help us answer questions about the company’s revenue, current margin, cost of goods sold, and net revenue. This report moves from Revenue (sales) and subtracts company-related expenses at each step until the final line shows the earnings per share (EPS).
Balance Sheet – This is the balance sheet report. It will answer our questions regarding the company’s debts. It will list the company’s Assets, the amount of short-term and long-term Liabilities, and will also clearly show the difference between assets and liabilities, i.e., the company’s Equity (capital).
Cash Flow – The cash flow statement. It provides detailed information about the company’s cash flows from its business operations (Operating Activities), investments made by the company (Investing Activities), and cash flows arising from loans (Financing Activities).
In the next articles, we will examine each report individually.