Fundamentalists believe that eventually the market will reflect the security's real worth.
The fundamentalist strives to be relatively immune to the optimism and pessimism of the crowd and makes a sharp distinction between a stock's current price and its true value.
In estimating the firm-foundation value of a stock, the fundamentalist's most important job is to estimate the firm's future stream of earnings and dividends. The worth of a share is taken to be the present or discounted value of all the cash flows the investor is expected to receive. The analyst must estimate the firm's sales level, operating costs, tax rates, depreciation, and the sources and costs of its capital requirements.
The fundamentalist uses four basic determinants to help estimate the proper value for any stock.
1. The expected growth rate.
Rule: A rational investor should be willing to pay a higher price for a share the larger the growth rate of dividends and earnings.
Rule: A rational investor should be willing to pay a higher price for a share the longer an extraordinary growth rate is expected to last.
2. The expected dividend payout.
Rule: A rational investor should be willing to pay a higher price for a share, other things being equal, the larger the proportion of a company;s earnings that is paid out in cash dividends.
3. The degree of risk.
Rule: A rational (and risk averse) investor should be willing to pay a higher price for a share, other things being equal, the less risky the company's stock.
4. The level of market interest rates.
Rule: A rational investor should be willing to pay a higher price for a share, other things being equal, the lower the interest rates.
The above valuation rules imply that a security's firm-foundation value (and its price-earnings multiple) will be higher
- the larger the company's growth rate and the longer its duration;
- the larger the dividend payout for the firm;
- the less risky the company's stocks; and
- the lower the general level of interest rates.
Why might fundamental analysis fail to work?
There are three potential flaws in this type of analysis.
1. The information and analysis may be incorrect.
2. The security analyst's estimate of "value" maybe faulty.
3. The market may not correct its "mistakes", and the stock price may not converge to its value estimate.