Fundamental equity analysis

04 June 2018 by National Bank
Fundamental equity analysis

A previous article presented a complete process for assembling a portfolio. We will now provide more details on the selection of stocks using fundamental analysis (FA).

1. What is fundamental equity analysis?

Few investment principles are more unanimously agreed upon than the fact that the current value of a financial asset is determined by the present value of the cash flows it will generate in the future. For stocks, their value (or “intrinsic value”) corresponds to the current value of future dividends[1]. Since there is no consensus on future dividends or the discount rate, share prices fluctuate based on news concerning the company, meaning they hover around the intrinsic value (“real” value). FA involves analyzing factors that influence the company’s short- and long-term situation, such as the impact on the earnings of a sawmill that could potentially see an increase in tariffs on softwood lumber

2. Fundamental analysis involves different types of analysis.

It includes: macroeconomic analysis (most general), sector analysis, and the analysis of company-specific factors (most detailed).

On a macroeconomic level, the analyst will attempt to determine three things:

  1. Will economic growth exceed or fall short of expectations?
  2. Will inflation exceed or fall short of expectations?
  3. Will investors be inclined to take more or less risk going forward than at present?

Du point de vue macroéconomique, l’analyste tentera de déterminer trois choses :

If economic activity (i.e. economic growth) exceeds expectations, share prices should rise, as earnings should be higher than expected. The case with inflation is more subtle. In general, equity prices suffer somewhat when inflation proves higher than expected, as although inflation tends to boost earnings, it also works in the opposite direction by increasing the rate of return required on equity investments. Lastly, when investors exhibit more risk tolerance (for example, when the threat of a war subsides, as the news regarding North Korea suggests), equity prices will generally go up.

In terms of sectors, FA focuses on:

  1. The appeal of the company’s products or services for clients (example: the ergonomics of the first iPhones);
    2. The company’s competitive edge (example: Amazon’s technological advantage);
    3. The company’s situation with regard to its suppliers and employees (example: battery manufacturers who go to great lengths to secure their cobalt supplies);
    4. The possible arrival of an alternate product or service or disruptive technology (example: the taxi industry versus Uber).

Lastly, with regard to company-specific factors, FA focuses especially on the company’s profitability. This does not simply involve calculating profit margins and related ratios[2], but also determining why they are where they are and where they should go next. Being able to better estimate future earnings growth than “the market” is the most crucial element for measuring and taking advantage of overvalued or undervalued equities. For example, let’s say that the market reckons on a 4% annual growth in earnings and an annual return of 10% is required on a stock. If the analyst believes instead that the growth will reach 6% and is proven right, the price of the shares can be shown to be undervalued by more than 50%!

3. Disclaimer.

The FA principles and examples presented above are simple, which could lead you to believe that it is easy to determine whether a stock is overvalued or undervalued. Don’t be fooled: it is very difficult to consistently beat the market consensus that is reflected in the price of a stock.

This article is an overview of the FA of stock prices. FA is a serious and viable approach for stock picking and it is extremely widespread among investment professionals. To expand your knowledge on the subject, a number of good books are available, including the following:

  • Introduction: Krantz, Fundamental Analysis for Dummies, 2016
  • A classic: Graham and D. Dodd, Security Analysis, 6th edition, 2009
  • Focusing on financial ratios: Tracy, Ratio Analysis Fundamentals, 2012

Edited by Pierre Laroche

[1] Some will say that it also depends on the future price at which it will be resold; this is true, but the future price in question will itself correspond to the present value at that time of subsequent dividends.

[2] Analyzing financial ratios is an important element of FA, but it is beyond the scope of this short article.

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