Sunday, April 25, 2010

Fundamental Analysis (Part 2)

A Guest Post by Ange Lim

A Primer on Valuation

At this point, let’s recap. You have your choice company and its benchmark, and you’ve computed some key ratios. So basically you already know how the company is performing relative to its closest competitor. If the financials look good, then it’s possible that the company may be a good investment. But before you put your money into the stock, there’s one last important step to take: valuation.

Valuation is a tool to know whether a stock is currently undervalued or overvalued. For example, if the stock’s intrinsic value is 20 pesos and it is currently trading at 15, then it is undervalued; buying the stock now will provide you with a margin of safety of 5 pesos, an amount you can potentially earn in the future. Conversely, assuming still that the intrinsic value is 20 pesos, the stock is overvalued if it is trading at 25; clearly, the rational thing to do is to not buy the stock (or sell it if you own it) since it is currently very expensive, selling for more than what it’s worth.

There are different valuation methods that you can use, depending on the factors you consider important and the depth of the analysis you want to make. The three most commonly used valuation methods are P/E Ratio Valuation, the Dividend Discount Model, and the Net Asset Value Approach.

P/E Ratio Valuation works under the assumption that firms of the same size in the same industry share the same P/E Ratio, which is computed by dividing a company’s current stock price by expected earnings per share (EPS), which in turn is computed by dividing a firm’s expected Net Income by the total number of outstanding shares of common stock. This method requires an assumed value for the industry P/E Ratio, which may be derived by getting the average P/E of the major players in the industry. To get an estimate of the intrinsic value of a stock, simply multiply the industry P/E ratio with the firm’s expected EPS next year. This approach’s simplicity unfortunately comes with two important caveats: one, by considering only next year’s expected earnings, the method does not completely capture the firm’s ability to generate earnings and cash flows in the future; two, remember that accounting data like Net Income is often a result of the creative interpretation of a professional auditor (sometimes at the behest of the company’s management), so you should always double check how this figure was computed.

The second method is the Dividend Discount Model, which is based on the general idea that the true worth of anything is equal to the present value of all cash flows that thing is expected to generate in the future, and the assumption that the company will continue to operate as a going concern in the indefinite future. A share of common stock that is planned to be sold in year t will generate dividends, D, every year up to year t, and an amount equal to the stock’s price in year t, Pt. Assuming that you can earn at an interest rate k from a similarly risky investment, then the intrinsic value of the stock is given by the equation:

Notice that to make the formula work, you’ll have to have estimates for future dividends, the stock price in year t, and the discount rate, k; you’ll have to rely on the points listed in the last post to make these estimates. You have been warned: fundamental analysis is a complicated process.

Finally, we have the Net Asset Value (NAV) Approach. This kind of valuation takes into account the company’s liquidation value, which is the amount you’ll get if you sell the company’s assets piecemeal. To do this, you’ll have to read the notes to the financial statements found in the latest annual report as well as the MD&A. Ideally, you should only consider the market value of the company’s assets, but more likely than not you’ll just end up using balance sheet book values instead. Which is not particularly bad, since NAV often just serves as a floor figure for the firm’s intrinsic value.

Why Even Bother

You might be wondering now why you should go through all the trouble of reading financial statements and analyzing macroeconomic variables and computing for intrinsic value when stock brokers can easily provide you with their own estimates. Here are some benefits of doing your own fundamental analysis (besides sounding smart when discussing trading techniques with friends):

1. You’ll get a clearer picture of the present condition of a company. No one’s going to be able to fool you into buying stocks being falsely marketed as good investments.

2. You’ll know at what price the stock should fall before it becomes a good buy and at what price you should start consider selling so you’ll be able to prepare yourself and your portfolio accordingly.

3. You’ll gain the confidence you’ll need to make basic investment decisions such as buy, hold, and sell (trading tends to affect people psychologically since it’s real money we’re dealing with here). The short-term price volatilities that will arise won’t heavily influence your rationality when it comes to decision-making.

4. You’ll have some form of independence. With this new skill, you won’t have to always rely on your brokers or their research (maybe just use them as reference afterwards). They couldn’t have made fundamental analyses of all possible stocks, right? Maybe the one you’re looking for hasn’t been detected by their radar yet.

5. You’ll increase the possibility of earning handsome profits from the stock market. Keep in mind that there are some stocks that people aren’t aware of yet but will prove to be a great bargain down the road. Like the fourth advantage, maybe you spot a stock that’s too small for major analysts to cover but has the makings of a value investment. In trading, timing is everything.

To sum things up, think of doing your own fundamental analysis as your source of competitive advantage—not many people will go the extra mile to earn more than they normally would sticking to what their brokers advise. Being equipped with the right tools will give you the advantage you need to outperform even your own expectations. After all, knowledge is a very powerful thing...especially when it comes to money matters. Happy analyzing!

Click here for Part 1.
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