FUNDAMENTALS: QUANTITATIVE AND QUALITATIVE
You could define fundamental analysis as
"researching the fundamentals", but that doesn't tell you a whole lot
unless you know what fundamentals are. As we mentioned in the introduction, the
big problem with defining fundamentals is that it can include anything related
to the economic well-being of a company. Obvious items include things like
revenue and profit, but fundamentals also include everything from a company's
market share to the quality of its management.
The various fundamental factors can be grouped into two categories: quantitative and qualitative. The financial meaning of these terms isn't all that different from their regular definitions. Here is how the MSN Encarta dictionary defines the terms:
The various fundamental factors can be grouped into two categories: quantitative and qualitative. The financial meaning of these terms isn't all that different from their regular definitions. Here is how the MSN Encarta dictionary defines the terms:
- Quantitative – capable of being
measured or expressed in numerical terms.
- Qualitative – related to or
based on the quality or character of something, often as opposed to its
size or quantity.
In our context, quantitative fundamentals are
numeric, measurable characteristics about a business. It's easy to see how the
biggest source of quantitative data is the financial statements. You can
measure revenue, profit, assets and more with great precision.
Turning to qualitative fundamentals, these are the less tangible factors surrounding a business - things such as the quality of a company's board members and key executives, its brand-name recognition, patents or proprietary technology.
QUANTITATIVE MEETS QUALITATIVE
Turning to qualitative fundamentals, these are the less tangible factors surrounding a business - things such as the quality of a company's board members and key executives, its brand-name recognition, patents or proprietary technology.
QUANTITATIVE MEETS QUALITATIVE
Neither qualitative nor quantitative analysis is
inherently better than the other. Instead, many analysts consider qualitative
factors in conjunction with the hard, quantitative factors. Take the Coca-Cola
Company, for example. When examining its stock, an analyst might look at the
stock's annual dividend payout, earnings per share, P/E ratio and many other
quantitative factors. However, no analysis of Coca-Cola would be complete
without taking into account its brand recognition. Anybody can start a company
that sells sugar and water, but few companies on earth are recognized by
billions of people. It's tough to put your finger on exactly what the Coke
brand is worth, but you can be sure that it's an essential ingredient
contributing to the company's ongoing success.
THE CONCEPT OF INTRINSIC VALUE
THE CONCEPT OF INTRINSIC VALUE
Before we get any further, we have to address
the subject of intrinsic value. One of the primary assumptions of fundamental
analysis is that the price on the stock market does not fully reflect a stock's
"real" value. After all, why would you be doing price analysis if the
stock market were always correct? In financial jargon, this true value is known
as the intrinsic value.
For example, let's say that a company's stock was trading at $20. After doing extensive homework on the company, you determine that it really is worth $25. In other words, you determine the intrinsic value of the firm to be $25. This is clearly relevant because an investor wants to buy stocks that are trading at prices significantly below their estimated intrinsic value.
This leads us to one of the second major assumptions of fundamental analysis: in the long run, the stock market will reflect the fundamentals. There is no point in buying a stock based on intrinsic value if the price never reflected that value. Nobody knows how long "the long run" really is. It could be days or years.
This is what fundamental analysis is all about. By focusing on a particular business, an investor can estimate the intrinsic value of a firm and thus find opportunities where he or she can buy at a discount. If all goes well, the investment will pay off over time as the market catches up to the fundamentals.
The big unknowns are:
1)You don't know if your estimate of intrinsic value is correct; and
2)You don't know how long it will take for the intrinsic value to be reflected in the marketplace.
CRITICISMS OF FUNDAMENTAL ANALYSIS
For example, let's say that a company's stock was trading at $20. After doing extensive homework on the company, you determine that it really is worth $25. In other words, you determine the intrinsic value of the firm to be $25. This is clearly relevant because an investor wants to buy stocks that are trading at prices significantly below their estimated intrinsic value.
This leads us to one of the second major assumptions of fundamental analysis: in the long run, the stock market will reflect the fundamentals. There is no point in buying a stock based on intrinsic value if the price never reflected that value. Nobody knows how long "the long run" really is. It could be days or years.
This is what fundamental analysis is all about. By focusing on a particular business, an investor can estimate the intrinsic value of a firm and thus find opportunities where he or she can buy at a discount. If all goes well, the investment will pay off over time as the market catches up to the fundamentals.
The big unknowns are:
1)You don't know if your estimate of intrinsic value is correct; and
2)You don't know how long it will take for the intrinsic value to be reflected in the marketplace.
CRITICISMS OF FUNDAMENTAL ANALYSIS
The biggest criticisms of fundamental analysis
come primarily from two groups: proponents of technical analysis and believers of the "efficient market hypothesis".
Technical analysis is the other major form of security analysis. We're not going to get into too much detail on the subject. (More information is available in our Introduction to Technical Analysis tutorial.)
Put simply, technical analysts base their investments (or, more precisely, their trades) solely on the price and volume movements of securities. Using charts and a number of other tools, they trade on momentum, not caring about the fundamentals. While it is possible to use both techniques in combination, one of the basic tenets of technical analysis is that the market discounts everything. Accordingly, all news about a company already is priced into a stock, and therefore a stock's price movements give more insight than the underlying fundamental factors of the business itself.
Followers of the efficient market hypothesis, however, are usually in disagreement with both fundamental and technical analysts. The efficient market hypothesis contends that it is essentially impossible to produce market-beating returns in the long run, through either fundamental or technical analysis. The rationale for this argument is that, since the market efficiently prices all stocks on an ongoing basis, any opportunities for excess returns derived from fundamental (or technical) analysis would be almost immediately whittled away by the market's many participants, making it impossible for anyone to meaningfully outperform the market over the long term.
Technical analysis is the other major form of security analysis. We're not going to get into too much detail on the subject. (More information is available in our Introduction to Technical Analysis tutorial.)
Put simply, technical analysts base their investments (or, more precisely, their trades) solely on the price and volume movements of securities. Using charts and a number of other tools, they trade on momentum, not caring about the fundamentals. While it is possible to use both techniques in combination, one of the basic tenets of technical analysis is that the market discounts everything. Accordingly, all news about a company already is priced into a stock, and therefore a stock's price movements give more insight than the underlying fundamental factors of the business itself.
Followers of the efficient market hypothesis, however, are usually in disagreement with both fundamental and technical analysts. The efficient market hypothesis contends that it is essentially impossible to produce market-beating returns in the long run, through either fundamental or technical analysis. The rationale for this argument is that, since the market efficiently prices all stocks on an ongoing basis, any opportunities for excess returns derived from fundamental (or technical) analysis would be almost immediately whittled away by the market's many participants, making it impossible for anyone to meaningfully outperform the market over the long term.
Fundamental analysis seeks to determine the
intrinsic value of a company's stock. But since qualitative factors, by
definition, represent aspects of a company's business that are difficult or impossible
to quantify, incorporating that kind of information into a pricing evaluation
can be quite difficult. On the flip side, as we've demonstrated, you can't
ignore the less tangible characteristics of a company.
In this section we are going to highlight some of the company-specific qualitative factors that you should be aware of.
BUSINESS MODEL
In this section we are going to highlight some of the company-specific qualitative factors that you should be aware of.
BUSINESS MODEL
Even before an investor looks at a company's
financial statements or does any research, one of the most important questions
that should be asked is: What exactly does the company do? This is referred to
as a company's business model – it's how a company makes money. You can get a
good overview of a company's business model by
checking out its website or reading the first part of its10-K
filing (Note: We'll
get into more detail about the 10-K in the financial statements chapter. For
now, just bear with us).
Sometimes business models are easy to understand. Take McDonalds, for instance, which sells hamburgers, fries, soft drinks, salads and whatever other new special they are promoting at the time. It's a simple model, easy enough for anybody to understand.
Other times, you'd be surprised how complicated it can get. Boston Chicken Inc. is a prime example of this. Back in the early '90s its stock was the darling of Wall Street. At one point the company's CEO bragged that they were the "first new fast-food restaurant to reach $1 billion in sales since 1969". The problem is, they didn't make money by selling chicken. Rather, they made their money from royalty fees and high-interest loans to franchisees. Boston Chicken was really nothing more than a big franchisor. On top of this, management was aggressive with how it recognized its revenue. As soon as it was revealed that all the franchisees were losing money, the house of cards collapsed and the company went bankrupt.
At the very least, you should understand the business model of any company you invest in. The "Oracle of Omaha", Warren Buffett, rarely invests in tech stocks because most of the time he doesn't understand them. This is not to say the technology sector is bad, but it's not Buffett's area of expertise; he doesn't feel comfortable investing in this area. Similarly, unless you understand a company's business model, you don't know what the drivers are for future growth, and you leave yourself vulnerable to being blindsided like shareholders of Boston Chicken were.
COMPETITIVE ADVANTAGE
Sometimes business models are easy to understand. Take McDonalds, for instance, which sells hamburgers, fries, soft drinks, salads and whatever other new special they are promoting at the time. It's a simple model, easy enough for anybody to understand.
Other times, you'd be surprised how complicated it can get. Boston Chicken Inc. is a prime example of this. Back in the early '90s its stock was the darling of Wall Street. At one point the company's CEO bragged that they were the "first new fast-food restaurant to reach $1 billion in sales since 1969". The problem is, they didn't make money by selling chicken. Rather, they made their money from royalty fees and high-interest loans to franchisees. Boston Chicken was really nothing more than a big franchisor. On top of this, management was aggressive with how it recognized its revenue. As soon as it was revealed that all the franchisees were losing money, the house of cards collapsed and the company went bankrupt.
At the very least, you should understand the business model of any company you invest in. The "Oracle of Omaha", Warren Buffett, rarely invests in tech stocks because most of the time he doesn't understand them. This is not to say the technology sector is bad, but it's not Buffett's area of expertise; he doesn't feel comfortable investing in this area. Similarly, unless you understand a company's business model, you don't know what the drivers are for future growth, and you leave yourself vulnerable to being blindsided like shareholders of Boston Chicken were.
COMPETITIVE ADVANTAGE
Another business consideration for investors is
competitive advantage. A company's long-term success is driven largely by its
ability to maintain a competitive advantage - and keep it. Powerful competitive
advantages, such as Coca Cola's brand name and Microsoft's domination of the
personal computer operating system, create a moat around
a business allowing it to keep competitors at bay and enjoy growth and profits.
When a company can achieve competitive advantage, its shareholders can be well
rewarded for decades.
Professor Porter argues that, in general, sustainable competitive advantage gained by:
|
A BRIEF INTRODUCTION TO
VALUATION
While the concept behind discounted
cash flow analysis is
simple, its practical application can be a different matter. The premise of the
discounted cash flow method is that the current value of a company is simply
the present value of its future cash flows that are attributable to
shareholders. Its calculation is as follows:
 |
For simplicity's sake, if we know that a company will generate $1 per share in
cash flow for shareholders every year into the future; we can calculate what
this type of cash flow is worth today. This value is then compared to the
current value of the company to determine whether the company is a good
investment, based on it being undervalued or overvalued.
There are several different techniques within the discounted cash flow realm of valuation, essentially differing on what type of cash flow is used in the analysis. The dividend discount model focuses on the dividends the company pays to shareholders, while the cash flow model looks at the cash that can be paid to shareholders after all expenses, reinvestments and debt repayments have been made. But conceptually they are the same, as it is the present value of these streams that are taken into consideration.
As we mentioned before, the difficulty lies in the implementation of the model as there are a considerable amount of estimates and assumptions that go into the model. As you can imagine, forecasting the revenue and expenses for a firm five or 10 years into the future can be considerably difficult. Nevertheless, DCF is a valuable tool used by both analysts and everyday investors to estimate a company's value.
For more information and in-depth instructions, see the Discounted Cash Flow Analysis tutorial.
RATIO VALUATION
There are several different techniques within the discounted cash flow realm of valuation, essentially differing on what type of cash flow is used in the analysis. The dividend discount model focuses on the dividends the company pays to shareholders, while the cash flow model looks at the cash that can be paid to shareholders after all expenses, reinvestments and debt repayments have been made. But conceptually they are the same, as it is the present value of these streams that are taken into consideration.
As we mentioned before, the difficulty lies in the implementation of the model as there are a considerable amount of estimates and assumptions that go into the model. As you can imagine, forecasting the revenue and expenses for a firm five or 10 years into the future can be considerably difficult. Nevertheless, DCF is a valuable tool used by both analysts and everyday investors to estimate a company's value.
For more information and in-depth instructions, see the Discounted Cash Flow Analysis tutorial.
RATIO VALUATION
Financial ratios are mathematical calculations
using figures mainly from the financial statements, and they are used to gain
an idea of a company's valuation and financial performance. Some of the most
well-known valuation ratios are price-to-earnings and price-to-book. Each valuation ratio uses
different measures in its calculations. For example, price-to-book compares the
price per share to the company's book value.
The calculations produced by the valuation ratios are used to gain some understanding of the company's value. The ratios are compared on an absolute basis, in which there are threshold values. For example, in price-to-book, companies trading below '1' are considered undervalued. Valuation ratios are also compared to the historical values of the ratio for the company, along with comparisons to competitors and the overall market itself.
The calculations produced by the valuation ratios are used to gain some understanding of the company's value. The ratios are compared on an absolute basis, in which there are threshold values. For example, in price-to-book, companies trading below '1' are considered undervalued. Valuation ratios are also compared to the historical values of the ratio for the company, along with comparisons to competitors and the overall market itself.
CONCLUSION
Whenever you're thinking of investing in a company it is vital that you understand what it does, its market and the industry in which it operates. You should never blindly invest in a company.
One of the most important areas for any investor to look at when researching a company is thefinancial statements. It is essential to understand the purpose of each part of these statements and how to interpret them.
