fundamental analysis

As with the analysis of fixed income securities, equities may be analyzed on an expected future cash flow, or benefit, to the shareholder basis. When reading the financial papers one often encounters the term "intrinsic value". This concept is what is considered to be the corner stone of fundamental analysis.

How does an investor determine if a stock is undervalued, overvalued, or trading at fair market value? With fundamental analysis, this may be done by applying the concept of intrinsic value. If all the information regarding a corporation's future anticipated growth, sales figures, cost of operations, and industry structure, among other things, are available and examined, then the resulting analysis is said to provide the intrinsic value of the stock.

To a fundamentalist, the market price of a stock tends to move towards its intrinsic value. If the intrinsic value of a stock is above the current market price, the investor would purchase the stock. However, if the investor found through analysis that the intrinsic value if a stock was below the market price for the stock, the investor would sell the stock from their portfolio or take a short position in the stock.

There are several steps associated with fundamental analysis. The investor must make an examination of the current and future overall health of the economy as a whole. Attempt to determine the short-, medium- and long-term direction and level of interest rates. This may done through interest rate forecasting. An understanding of the industry sector involved, including the maturity of the sector and any cyclical effects that the overall economy have on it, is also necessary.

Once these steps have been undertaken, then the individual firm must be analyzed. This analysis must include the factors which give the firm a competitive advantage in its sector (low cost producer, technological superiority, distribution channels, etc.). As well, an in-depth look at the firm must be undertaken. Such factors as management experience and competence, history of performance, accuracy of forecasting revenues and costs, growth potential, etc., must be examined.

All the steps above give a qualitative overview of the firm's position within its sector and the economy as a whole. This is necessary in order to understand whether a quantitative analysis should be undertaken. If numbers must come into play, there are two relatively simple models which can be helpful for the investor willing to better understand the firm being investigated for investment. The two most commonly used methods for determining the intrinsic value of a firm are the dividend discount model, and the price/earnings model. Both methods if employed properly should produce similar intrinsic values.

When using the dividend discount model, the type of industry involved and the dividend policy of the industry is important in choosing which of the dividend discount models to employ. As mentioned earlier, the intrinsic value of a share is the future value of all dividend cash flows discounted at the appropriate discount factor. For those familiar with the calculation of yield in fixed income analysis, the concepts are similar.

For constant dividends:

This method is useful for analyzing preferred shares where the dividend is fixed. However, the constant dividend model is limited in that it does not allow for future growth in the dividend payments for growth industries. As a result the constant growth dividend model may be more useful in examining a firm.

For constant dividend growth:

The constant dividend growth model is useful for mature industries, where the dividend growth is likely to be steady. Most mature blue chip stocks may be analyzed quickly with the constant dividend growth model. This model has its limitations when considering a firm which is in its growth phase and will move into a mature phase at some time in the future. A two stage growth dividend model may be utilized in such situations. This model allows for adjustment to the assumptions of timing and magnitude of the growth of the firm.

For the two stage growth model;

P=ⁿ_t=1[D₀(1+g₁)^t/(1+k_e)^t]+_t=n+1[D_n(1+g₂)^t-n/(1+k_e)^t]

The two stage model allows for greater flexibility in the testing of scenarios for the investor looking at a firm in its infancy or in a new industry.