Fundamental Analysis And The Fun Part

Foreword from ShareInvestor

This article “Fundamental Analysis And The Fun Part” by Mindy Tan was first published in The Business Times on 30 Apr 2012 and is reproduced in this blog in its entirety.

While ‘mall research’ can help, it can’t replace a detailed analysis of a company to determine the intrinsic value of its stock, a don tells MINDY TAN

To what extent would you discount someone who claims to do his stockmarket research at the mall?

Investing legend Peter Lynch did just that in his 1993 book, Beating the Street: “Just before Christmas each year, I take my three daughters to the Burlington Mall for what is billed as a ‘Christmas present trip’ for them, but for me it is more of a ‘research trip’. I want them to lead me to their favourite retail stores, which – based on past experience – is a strong ‘buy signal’ for a stock.”

While using daily experiences to identify potential investments is a plausible stockpicking strategy, Ravi Jain, professor of finance and senior lecturer at the NUS Business School, says this should be followed by a “detailed analysis of the company”.

Such is the approach that fundamental analysts – a school of thought which boasts the likes of Warren Buffett and Jim Rogers – would take.

Broadly speaking, fundamental analysis embodies both quantitative and qualitative analysis to determine the intrinsic value of a company’s stock.

The field of fundamental analysis is based on two main assumptions:

  • Share prices do not fully reflect a stock’s real/intrinsic value.
  • In the long run, the stock market will reflect the fundamentals.

So a large part of fundamental analysis involves studying a company’s financial statements, business model and comparative advantage as well as the overall economy and industry trends to determine the firm’s value, and gain insight into its future performance.

In particular, “valuation techniques (are useful) to check whether the price of the company already reflects its earnings and growth prospects”, says Prof Jain.

He explains: “For example, if other investors had also found this company attractive and invested in it before us, then it is quite conceivable that the stock price has already been bid up substantially with little room for further appreciation.”

In valuing stocks, one of the more frequently used methods is the “relative valuation approach”, which compares a stock’s valuation with that of other stocks, or with the company’s own historical valuation.

Stock valuation is commonly calculated using the price-earnings (or PE) ratio, which is calculated using the stock’s current price divided by its earnings per share (EPS).

EPS is defined as the portion of a company’s profit allocated to each outstanding share of common stock. EPS also serves as an indicator of a company’s profitability.

Investors may use either the trailing PE ratio, which is based on the EPS for the previous 12 months – that is, calculated by taking the current stock price and dividing it by the previous 12 months; or the forward PE ratio, which is based on the EPS for the coming year.

Prof Jain explains: “In general, if two stocks (A and B) are very similar in all respects, such as the nature of their business, their risk, the level of debt, future growth rates, etc, then one should expect their PE ratios to be similar.

“So if Stock A has an EPS of $1 and its stock price is $10 (that is, the PE ratio is 10) then Stock B with an EPS of $2 should be ideally priced at $20, so that its PE ratio is the same as that of Stock A.

“If Stock B was trading at $18, with a PE ratio of 9, then we could consider that a buying opportunity. In other words, we would view Stock B to be underpriced relative to Stock A.”

In practice, however, one has to be very careful in applying this technique as the benchmark or comparable stocks should have similar characteristics and growth prospects, says Prof Jain.

He adds: “Companies and industries with lower risks and higher growth rates should command higher PE ratios. Let’s assume that two stocks (X and Y) have the same trailing EPS of $1 but Stock X’s earnings are expected to stay constant for the foreseeable future, whereas Stock Y’s earnings are expected to grow at a high rate.

“In this case, investors should be willing to pay a higher price for Stock Y. In other words, it would be reasonable to expect Stock Y to command a higher PE ratio than Stock X.”

Apart from the quality of the managers and financial factors – like the profitability of the company, how much debt it has, the expected growth rate of sales and profits – investors should also consider the qualitative factors that define a firm’s sustainable advantage over others, says Prof Jain.

“After all, a company’s ability to outperform over the long term depends a lot on whether or not it can maintain a strong competitive positioning in its industry.

“So it would be useful to analyse if the company’s products or services are very different from its competitors’. Such differentiation may arise due to the company’s brand recognition, its reputation for quality, durability and reliability, or from some technological advantage that the company has relative to other firms in the industry.

“Finally, beyond the company and its industry, it would be useful to have an understanding of global trends and general economic conditions, and how these may impact the firm.”

He adds that before you head off to the mall in the name of research, it is worth remembering that this approach may only help to identify companies whose products or services you come into contact with.

Says Prof Jain: “To build a diversified portfolio, we should invest in a broad range of companies including the ones whose customers are not individuals but government agencies or other businesses.”