As mentioned in the last post, this week we’ll expand on fundamental analysis. It was described as follows in Analyzing Analysts:
When looking at the fundamentals of a stock, it generally means evaluating revenue, valuation and industry trends to determine whether a stock is undervalued or overvalued. To determine value, a fundamentalist would look closely at a company’s assets, expected earnings growth, dividend payouts, the level of market interest rates and risk. Most analysts would claim to lean more toward using fundamentals over technicals in their stock ratings. An analyst’s success in employing fundamental analysis largely comes down to accurately estimating future earnings.
According to Burton G. Malkiel, author of A Random Walk Down Wall Street, the fundamental analyst uses four underlying factors to help estimate the value of a stock:
Expected Growth Rate
Fundamentalists consider the impact of compound growth in combination with an understanding of the economics of the industry that the company in question is in. Remember, compounding is the magic that makes 10+10 = 21, where the interest you earn on your initial investment of $10 earns interest too, over and over again. The hope is that by studying industry conditions, the analyst will surface insights that are not yet reflected in market prices. Some assumptions about the company’s sustained growth will then be made. The risk lies in whether the assumptions are any good and how long a growth rate will last. But there’s really no avoiding the assumptions as share prices must account for differences in growth potential. It’s the only way to make sense of market valuations. Is there a way to rate the quality of analysts’ assumptions? We’ll be tackling this question at UVstocks.io down the road.
Expected Dividend Payout
The amount a stock pays in dividends is factored into whether a stock’s price is fairly valued, undervalued or overvalued. If two stocks have equal expected growth rates, the one that pays a dividend would seem to have a higher value. There are, however, fabulous growth stocks that don’t pay dividends. And there are stocks that offer high dividend yield but are poor investments (see Dividend Investing post). Then there are companies that choose to buy back stocks instead of paying dividends. Stock buybacks reduce the number of outstanding shares, thereby increasing the ownership stake of current shareholders. A company may choose to buy back to reward shareholders, reduce dilution caused by employ stock option plans or capitalize on undervalued shares.
Degree of Risk
Another factor that impacts a stock’s valuation is risk. Generally, investors tend to favor lower-risk, high-quality stocks. Analysts spend a lot time assessing risk profiles. The more the risk, the greater the potential for higher future returns. Though measuring risk is difficult, there are certain categories of stocks that an investor can look to for risk protection. Stalwart stocks with steady dividend payouts that are less affected by the consumer dollar and recessions, are attractive to risk-averse investors. Let’s say the market drops by 20%, a stalwart like Coca-Cola (KO) may only dip by 10%. While a fast growing, high-tech stock may plummet 30%. In good times, however, the tech stock will outpace the safer stalwart stock.
Level of Market Interest Rates
Historically, when interest rates are rising, stock prices tend to fall. And bonds naturally become more attractive, because the higher returns come with a lower risk. Investors, in turn, gravitate less toward stocks given the level of risk you must incur to yield returns that wouldn’t be much better than bonds. When rates are down (like they were in years leading up to 2020), investors want to park their money into equities. Note that 2022 was an exception to the negative correlation between stocks and bonds—both were down. It was the worst year on record for bonds. They couldn’t keep up with the Fed’s aggressive rate hikes.
“People worry about the riskiness of stocks, but bonds can be just as risky.” — Peter Lynch
A rational investor makes investment decisions based on sound analysis and logic, which aligns more closely with the fundamentalist’s approach, more so than the technician. So to summarize, a rational investor should (according to Malkiel):
Be willing to pay a higher price for a share the longer an extraordinary growth rate is expected to last.
Pay a higher price for a share, other things equal, the larger the proportion of a company’s earnings paid out in cash dividends or used to buy back stock.
Pay a higher price for a share, other things equal, the less risky the company’s stock.
Pay a higher price for a share, other things equal, the lower the interest rates.
Next week we’ll cover Technical Analysis.
P.S. I'm sharing some investment information, but it's important to remember that what I'm providing is for informational purposes only and should not be construed as financial advice.
Happy Investing,
John
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