What is the fundamental analysis of a stock for dummies? Look into important metrics such as EPS (earnings per share), market capitalization, and ROE when getting started. FA suggests that the stock has an intrinsic value that can be calculated. This assumption fails in a few ways, and before performing doing research it is good to understand why a stock may not have a single intrinsic value.
Table of Contents
- Fundamental Analysis for Dummies
- What Are the Components of Fundamental Analysis?
Fundamental Analysis for Dummies
Do you know what fundamental analysis is when it comes to stock trading? Fundamental analysis for dummies, in essence, is evaluating the intrinsic value of a stock and analyze what could affect price in the future.
Fundamental Investors Will Value the Company Differently the Moment a Dividend Is Announced
First, investors, especially retail investors, have different preferences. If I like talking about technology with my friends, then owning a share of Facebook will give me something to talk about.
Facebook is often in the news and it has an interesting technology platform. A company like Dow Chemical may not offer me the same entertainment value.
I might therefore be more forgiving of under performance by Facebook than I would of Dow Chemical. That entertainment value has a price, although I might not know how to calculate it. In other words, fundamental analysis for dummies.
Investors Have Different Requirements
Suppose I have a choice of buying a bond that has a $50 interest payment (coupon) every six months, or a bond that has a $100 coupon every year.
If I’m trying to use the profits from the bond to pay an expense every six months, then the first bond is more valuable to me than the second bond; even though both pay approximately the same interest.
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Intrinsic Value and Fundamental Analysis for Dummies
The basis for fundamental analysis for dummies is intrinsic value. In order to account for these differences of opinion in intrinsic values, valuation science makes certain assumptions:
Firstly, intrinsic value can merely be thought of as an average intrinsic value. And the majority of investors will, on average, agree with the intrinsic value.
Some investors will value an instrument slightly higher and some lower. But on average the fundamental value of a stock is about the same for everyone who has similar needs.
A simpler way to say this is that the time value of money is the same for everyone. Receiving $50 every six months is slightly more valuable than receiving $100 every year because the $50 could be invested and earn a small return over the following six months.
Second, we assume that we can categorize most investor preferences by stating a required return. I might have a set of preferences that essentially mean I want a 7% annual return on my investments.
And you might have a set of preferences that mean you want an 8% annual return. Click here for our nightly list of penny stocks.
You can categorize investments into classes that provide certain returns. And by calculating the present value of these investments, the assumption is that most investors would agree with the present value IF at the same time the investors agreed with the data used to calculate present value. A grocery store may on average return 2% per year. Therefore the present value of any grocery store is based on the grocery store’s future profits discounted at 2% per year.
A software company may earn 7% per year on average. Thus any software company’s value is the company’s future profits discounted at 7% per year.
If you want to earn 7% per year on your investment you wouldn’t invest in a grocery store. Similarly, if you wanted to earn 2% per year you wouldn’t want the additional risk from investing in a software company versus a grocery store.
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What Are the Components of Fundamental Analysis?
If you want to learn fundamental analysis for dummies then what are the components you must study? There are three; economic analysis, industry analysis, and company analysis. Each of these three components factor heavily into how a company trades. And how you can invest in it.
Methods For Fundamental Analysis
Fundamental analysis for dummies starts by looking at two methods used to determine the fundamental value of a company; book value and comparables.
The book value of a company is merely the actual accounting value of its assets, which is usually the amount the company paid for its assets minus any depreciation.
If the company purchased a building and factory equipment one year ago, and it owns nothing else, then the book value of the company is the price paid for those items; minus any depreciation.
Book value is a good number to calculate, but it is usually not very accurate. If the company were to go out of business and sell its assets, there is no reason to expect the company to receive the amount of money it paid. It might receive much less.
In addition, book value tells you very little about profitability. You can compare two competitors by looking at the value of assets (you can assume that two factories producing the same product would need similar equipment).
However, all by itself, assets don’t tell you how much money the company makes. Ford makes cars and needs expensive and heavy machinery to do so.
But Microsoft makes software and only needs computers to build and test the software on. Thus, per dollar of profit, you would expect Microsoft to have fewer assets than Ford, or a lower book value
A Better Approach is Comparables
If you want to know what company A is worth, find companies B, C, D, etc. that are very similar and say that A is worth an average of B, C, D, etc.
All these companies may be different in size, so using book value makes sense as a basis of comparison. Taking the estimated value (or price) and dividing by book value gives you a simple number, called Price to Book Value, that is comparable to any other company’s Price to Book Value.
Consider three companies that make very similar products:
Company A has a book value of $1,000.00 and an estimated fundamental value of $4,000.00. It’s Price to Book value is $4.00.
Company B has a book value of $800.00 and an estimated fundamental value of $3,000.00. It’s Price to Book value is $3.75.
The average of the two values is $3.88.
Company C, which I am trying to value, has a book value of, say, $900.00. If I multiply the book value by $3.88, I now have an estimate of $3,492.00 for company C.
You can use almost any other comparable value in this way. For example, the PE ratio (Price to Earnings), or revenue.
You could even use inventory or dividends. Each method comes with inherent inaccuracies and using multiple ratios to perform fundamental valuation is common practice.
Ratios work very well for some industries and not well at all for others. Take a look at different ratios for firms in different sectors to get an idea of where the method works and where it falls short.
Fundamental analysis for dummies is finding out the different components that will affect stock price in the future.
Fundamental Analysis for Dummies Bottom Line
We recommend using StockRover for deep fundamental analysis. Thanks for reading our fundamental analysis for dummies post. Be sure to read part two of our series that’s coming out soon!