Calculating a Stock's Intrinsic Value (Actual Value)

You've found a great company, possibly the best investment opportunity in your lifetime...

Not only that, you understand the Basic Principle of Investor Return which says, "the price you pay determines your rate of return."

So all you have to do is take advantage of your expert knowledge and buy a great company at a great price.

Right?

Well, almost.

You've still got one problem left...

How do know a company's selling for a great price?

Easy...

You calculate its intrinsic value.

What's Intrinsic Value?

In his 1938 publication "The Theory of Investment Value," John Burr Williams first articulated the idea of calculating a stock's intrinsic value.

His idea essentially adds all of the expected future cash flows produced by a company and assigns them a present value. This present value represents the price you should pay.

So, in financial circles, "intrinsic value" is defined as the present value of all expected future net cash flows to the company.

Find that sentence a little hard to follow?

So do I.

That's why I prefer a definition that doesn't require a dictionary for interpretation.

Here it is...

Intrinsic value is the actual value of a company as opposed to its current market price.

That definition makes a lot more sense, doesn't it?

So why is intrinsic value important?

Because if you can calculate the actual value of a company, then...

You can compare it to the current market price.

If the current market price is higher, then you know the company is overvalued.

But if the current market price is lower, then you know the company is undervalued.

Knowing what's overvalued and what's undervalued is what separates successful stock market investors from the rest of the crowd.

Why?

Because if you know a company is undervalued, then...

You can buy low!

And buying low is the key to successful investing. Right?

Absolutely.

How Do You Calculate Intrinsic Value?

Sounds great, doesn't it?

But we still haven't tackled the problem...

How do you calculate a company's intrinsic value?

Well, first you need current information regarding your company's...

• Stock price
• Average return on equity
• Dividend payout ratio
• Equity per share (also known as book value per share)
• Earnings per share
• Average P/E ratio

Does all that information look intimidating?

Don't worry. We'll address how to easily find each piece of information soon. Fortunately, it's all on the Internet!

Once you have all this information at your fingertips, you can easily calculate your company's intrinsic value by estimating its earnings for the next ten years.

The following chart uses The Coca-Cola Company as an example to illustrate how easy this is...

We'll address how to use this chart in moment.

But first, let's get those figures...

How to Find the Numbers You Need

Before you can calculate a stock's intrinsic value, you need to know several pieces of information about the company and its stock.

Here's how to find each piece of information...

Current Stock Price - This one's easy. Just go to Yahoo! Finance or Google Finance or dozens of other places on the web where you can get real-time stock quotes. Plug in your company's stock ticker, and you've got it.

Average Return on Equity - While most online services like Yahoo! Finance provide a figure for return-on-equity, it most likely represents the current year only. To get a more accurate number for your intrinsic value calculation, go to Google Finance, type in your company's ticker symbol, and find the text link titled "More ratios from Thomson Reuters."

Follow that link, and you'll find a category titled "Management Effectiveness." Find the figure for "Return on Equity -5 yr. Avg."

It's best to use a company's five- or ten-year average return on equity as opposed to a single year when calculating intrinsic value.

Why?

Because a dramatically higher or lower one-year return on equity can throw off your entire calculation. So if you want the most accurate calculation possible, use a long-term average return on equity.

In my opinion, The Value Line Investment Survey offers the best return on equity figures. Visit your local library, and you can find a company's return on equity every year for the last ten years as well as Value Line's projections for the company's ROE over the next five years.

For best results, use Value Line figures for your intrinsic value calculations.

Current Dividend Payout Ratio - Again, go to Google Finance, type in your company's ticker symbol, and find the text link titled "More ratios from Thomson Reuters."

Follow that link, and you'll find a category titled "Dividends." Find the figure for "Payout Ratio (TTM)." That's the percentage of earnings your company pays out in dividends.

Current Equity Per Share - Go to Yahoo! Finance, type in your company's ticker symbol, and find the text link titled "Key Statistics." Find the category titled "Balance Sheet," and find the figure for "Book Value per Share." This is the current equity per share, also known as book value.

Current Earnings Per Share - Go to Yahoo! Finance, type in your company's ticker symbol, and find the figure for EPS. This is the earnings per share.

However, keep in mind that Yahoo! Finance and most online services report a company's last four quarterly earnings figures as the EPS, so this figure might be distorted by a one-time expense or charge-off due to otherwise favorable long-term investments by the company.

So make sure you perform due diligence when searching for an accurate earnings per share figure for your intrinsic value calculation. Again, The Value Line Investment Surveyprovides the most accurate figures.

Average P/E Ratio - This isn't a ratio I?ve run across on Yahoo! Finance or Google Finance, so I performed a Google search to find a good site. A site called ADVFN popped up. If you follow this link to their site, and scroll down to the category "Valuation Ratios," you'll find a figure titled "5-Y Average P/E Ratio." This is the company's five-year average P/E ratio.

But again, you can find a far more accurate ten-year P/E ratio by visiting your local library and consulting The Value Line Investment Survey. The figure they provide is the one I personally use.

Using Excel to Calculate Intrinsic Value

Once you've gathered all the necessary information, you can use Excel to calculate a stock's intrinsic value.

The previous image, using The Coca-Cola Company (KO), is a good example of this...

Do all those spreadsheet formulas and calculations look confusing?

Fortunately, I've already set them up for you!

All you have to do is plug in the customized numbers for your company...

And you can use the exact same Excel spreadsheet I use for calculating a company's intrinsic value.

Download Britt's Intrinsic Value Spreadsheet >>>

Just replace the numbers in the yellow-highlighted cells with your company's numbers, and the spreadsheet will calculate a value titled "Multiple" on line 29.

Line 29 is the calculation you're looking for.

If your great company has a number above 5.00, it's currently undervalued.

If it's below 5.00, then the stock is currently overvalued...

Why 5.00?

Because a multiple of 5.00 means you'll make a 5-fold return on your investment in the next ten years if you buy the company at its current price.

A 5-fold return in ten years is a 17.46% annual compounding rate of return.

Also, five is a nice round number, and I like nice round numbers.

No kidding...

Think that's a silly reason for picking 5.00?

It's really not.

Always keep in mind, calculating intrinsic value is an art, not an exact science.

The spreadsheet's calculations act as a guide, not a precise road map.

As Warren Buffett says...

"It's better to be approximately right than precisely wrong."

So a figure above 5.00 means you're approximately right.

But there's another reason you want a 5-fold investment return and not a 4-fold or a 6-fold return...

Remember, if achieved, a 5-fold return is a 17.46% annual compounding rate of return.

This beats the S&P 500's fifty year track record of 10.85% by more than six points.

Now, in order to make all your time and effort researching stocks a worthwhile endeavor, you need to beat the market by at least a couple of points per year.

Over time, those couple of points will add up to a lot.

And while achieving a 4-fold return over ten years (a 15% annual compounding rate of return) achieves your goal of beating the market by more than a few points...

You need to remember, calculating a stock's intrinsic value is an estimating tool. It's more art than exact science.

So as a precaution, give yourself a little room for error.

Force your potential investment to live up to a higher standard...

Tack an extra 25% onto that 4-fold return, and give yourself a new goal of a 5-fold return.

That way, if you fall short of your goal, you still have a good shot at beating the market averages.

Remember...

"It's better to be approximately right than precisely wrong."

So give yourself a little bit of leeway in case something goes wrong.

In investment circles, this idea is known as the margin of safety.

Providing a Margin of Safety

Benjamin Graham first put forth the idea of a margin of safety in his groundbreaking bookSecurity Analysis (1934), which he co-authored with colleague David Dodd.

According to Graham, margin of safety is the secret to a sound investment philosophy...

"Confronted with a like challenge to distill the secret of sound investment into three words, we venture the following motto, Margin of Safety."

So what's a margin of safety?

It's nothing more than giving yourself a little room for error.

Just ask yourself, "If things fail to go perfectly, will my investment still work out?"

If not, there's no margin of safety.

However, if your company's earnings fall well short of your projections and you can still achieve your desired investment returns...

Then, you have a margin of safety.

By purchasing only those stocks which offer a significant margin of safety, you limit your downside risk and significantly increase your odds of success.

Conclusion

Learn how to calculate a stock's intrinsic value. It's a skill that will prove invaluable over the course of your investing lifetime.

Use the spreadsheet located in the middle of this page. Look for companies with a multiple in excess of 5.00 at the current price.

However, remain mindful of other variables. Some companies look like they're dirt cheap, and they are. These companies will make you a fortune if you're prudent enough to buy them.

But other companies also look like they're dirt cheap, while in reality, they're grossly overvalued...

So how do you tell the difference?

By following all the rules previously outlined for finding a great company...

Also, I can't emphasize this enough - ask question after question about your company's future business prospects and apply your own common sense and good judgment. This will go a long way toward determining your investment success...

After all, if numbers told the entire story, no one would think about their investment decisions at all. We'd all just let computer programs "run the numbers" on our investments. Right?

http://www.your-roth-ira.com/calculating-a-stocks-intrinsic-value.html

How to Calculate Intrinsic Value for Stock Investing

How to Calculate Intrinsic Value
Discounted Earnings, Instead of Just Cash Flow

Summarized Overview

You will find information about why you should calculate intrinsic value in stock market investing, and step by step guide on how to do it.

You will also find information about which key financial ratios to use and what you have to do after calculating intrinsic value.

Why You should Calculate Intrinsic Value

Simply because, you don't buy any stock at any price, do you? Do you know why? Because you want as much return as possible!

The price you are paying is the ultimate determinant for the rate of return that you'll be earning. The higher the price you pay for it, you'll be getting lower rate of return. This is why, you need to know how much a stock worth. Once you know its value, you can identify which stocks are traded at discounted price.

However, buying a stock simply because it is cheap is not the right approach either. This is another reason to calculate intrinsic value. To buy quality stocks at discounted price, value for money right?

How to Calculate Intrinsic Value

The way to go is, search for stocks whose prospects you believe in ( with good stock pick method ) and then use a valuation technique to ensure the purchase price is acceptable. Here, I use net present value (NPV) formula.

How to do it? Let say you are valuing stock ABC,

From 13 years historical data, you get the information as above. To proceed, you also need to firm up your expectation based on your risk profile. In this example:

• I set my investment horizon as long as ten years from 2007. So that in 2018 I can use the fund to finance my children's study
• I am confident stock ABC will continue growing 13 per cent per year for the next ten years (13 years records prove this stock able to grow 13 per cent EPS per year)
• I assume stock ABC will be having the same PER and dividend payout by end of 2017 (or early in 2018)

I am expecting 12 per cent return on investment (ROI) so that my initial investment able to cover my children's tuition costs in ten years time.

Let's start calculating intrinsic value of stock ABC.

Step One: Forecast Share Price

First of all, you need to forecast its share price ten years down the road. In this case, I project the price for the next ten years using 13 per cent per year growth.

Step Two: Forecast Total Future Value

Secondly, you need to calculate the total future value. This must include the potential dividend as well.

Look, some investors doesn't care much about dividend. To them, dividend is just too small to be considered. But as it has effect to the total future value, it should be taken into consideration.

By the end of the day, you can compare the stock's profitability to others; which may not pay any dividend at all.

Step Three: Calculate Intrinsic Value

After having all these data, then only you can calculate the intrinsic value for stock ABC.

Step Four: Compare with Current Stock Price

The intrinsic value above is because my goal is to get 12 per cent per annum from this stock. If so, current stock's price, which is $33.50, is acceptable indeed (stock price is below the intrinsic value).

How Do You Calculate Intrinsic Value? Discounted Cashflow Discounted Dividend Discounted Earnings Never Calculate What For?

But if your goal is about getting 25 per cent per annum return on investment, the intrinsic value will be $22. In this case, the current stock price will no longer acceptable for you.

For this same reason, you can say that current stock price is suit to those who are aiming for 15 per cent return per annum (in economics, this called as Internal Rate of Return or IRR)

What's Next?

As you can see, intrinsic value can be relatively different from one investor to another depending on the expected return. Expecting very high return will limit your investment options. On the other hand, having very low expected return may as well better keep the cash in fixed deposit.

As an investor, it is crucial to set a realistic target on the expected profits.

It is better if before you calculate intrinsic value of your selected stock, assess your own risk profile first. This will help you to determine your realistic preferred return based on your need, ability and investing habits.

Eager to buy stock? Hang on first! You need to have the fair value as another comparison. This is what mention by Warren Buffet's guru, the margin of safety 

http://www.stock-investment-made-easy.com/calculate-intrinsic-value.html

Related Reading

How to Value Stock - 3 Methods Warren Buffet Wants You to Learn
If you are looking for ways on how to value stock, click here. I'll share with you 3 stock valuation model most commonly used by stock analyst.

Additional Reading

How to Determine Margin of Safety in Stock Investing
Margin of safety is a way to preserve capital. Find out how to determine fair value for each stock effectively.

Guide in Analyzing Company for Stock Investing
Four guidelines in analyzing company that you are about to invest in. Find how companies difference to each other.

Fundamental Analysis: Definition and Basic Guide for Beginners
Fundamental analysis is a practice that attempt to determine stocks’ valuation. This technique is focusing on the underlying factors that affect the company’s actual business performance.

Unlimited Profits From Good Stock Pick
Discover my simple but profitable stock screening criteria. It is proven to be a good stock pick strategy for all stock investors.

Related Books

Security Analysis
Security Analysis is the bible of fundamental analysis. Originally published in 1934, the tome systematically lays bare the science of security analysis.

Value Investing: From Graham to Buffett and Beyond (Wiley Finance)
Discusses where to look for underpriced securities, how to determine the intrinsic value of a stock, and alternative methods for constructing a portfolio that control risk without restricting investment return.

The Intelligent Investor: The Definitive Book on Value Investing. A Book of Practical Counsel (Revised Edition)
Among the library of investment books promising no-fail strategies for riches, Benjamin Graham's classic, The Intelligent Investor, offers no guarantees or gimmicks but overflows with the wisdom at the core of all good portfolio management.

Valuing a Business

"The critical investment factor is determining the intrinsic value of a business and paying a fair or bargain price."

- Warren Buffett

For practical purposes, it is sometimes sufficient to estimate either the upper bound or the lower bound of the investment value range of a stock.

The investment value of a stock is conceptually a single point value, the mean of the distribution of investment value. Operationally, investment value is estimated as a range of values. 


For practical purposes, it is sometimes sufficient to estimate either the upper bound of the investment value range to deselect a stock or the lower bound of the investment value range to select a stock. 

• As an example, if the upper bound of investment value of a given stock is confidently estimated to be no higher than $50 per share and the current quoted market price for this stock is $75 per share, then this particular stock can be deselected. 
• Similarly, if the lower bound of investment value of another stock is confidently estimated to be at least $50 per share and the current quoted market price for this stock is $25 per share, then this particular stock can be selected.

Concerning the range of estimated appraisal values, Williams (1954:32-33) explained: 
"Scholar: Yes, economics supplies the answer to many questions of great practical importance. 
Skeptic: How can it possibly do so if it lacks the mathematical precision of astronomy? 
Scholar: Economics is more like chemistry than it is like astronomy. Or rather, it is like that branch of chemistry known as qualitative analysis, in contrast to quantitative analysis. In economics, just as in qualitative analysis, you don't always have to have an exact answer to have a useful one. For instance, if a chemist testifies in court that a dead man was found to have enough arsenic in his system to kill an ox, let alone a human being, then it really doesn't matter whether the amount of arsenic involved is two grams or ten, so long as the chemist is absolutely sure that what he found was really arsenic and not a related substance like tin or antimony. Precise measurement is unnecessary. The same is true in economics.

The four basic factors needed to appraise the intrinsic value of an operating enterprise and thus its common stock equity

An important distinction is the difference between reported accounting value (book value or net worth per share) and intrinsic economic value (discounted future dividends per share).

• Book value does not reflect inflation and obsolescence, nor does it include intangible assets such as "franchises" and technological prowess resulting from R&D expenditures. 
• In addition, book value per share is merely a mechanical screening ratio set at an arbitrary cutoff point which does not reflect judgment and does not reliably distinguish between underpriced bargain stocks and fairly-priced junk stocks.

Intrinsic economic value of an operating enterprise is appraised by use of discounted cash flow techniques in the so-called dividend discount model originated by John Burr Williams.

• He made allowance for both dividends and future selling price. 
• He also explains how the transposed dividend discount model can be used to determine what the market as a whole is expecting, and this can be compared with the investor's expectation.

As John Burr Williams (1938: page 466) wrote: "in other words, Investment Analysis usually measures the relative rather than the absolute value of any stock, and leaves to the economist the broad question of whether stocks in general are selling too high or too low. ... From the point of view of this book, which is concerned with absolute rather than relative value, ... "

According to Williams (1938), the four basic factors needed to appraise the intrinsic value of an operating enterprise and thus its common stock equity, two economy-wide factors and two company-specific factors. The economy-wide factors are general price level inflation and the real interest rate. The company-specific factors are the estimated future net cash distributions to the stockholders and the discount rate or rates applied to those cash receipts. For foreign companies, a fifth factor may be required: the currency exchange rate, which is discussed at length by Williams (1954). This is important enough to justify a table to repeat it for emphasis.

Factors of Intrinsic Economic Value
Number	Description
1	general price level inflation rate
2	real interest rate
3	dividends or free cash flows to equity
4	discount rate or rates
5	currency exchange rate, where applicable

The quantity of value is an estimate or approximation. Intrinsic value can be quantified as Net Present Value (NPV) based on Discounted Cash Flow (DCF) analysis.

The quantity of value is an estimate or approximation. The estimated quantity of value is based on an appraisal or a valuation. It can be expressed either as 

• an interval estimate or 
• a range of quantitative values, or 
• as a single-point estimate or 
• a single quantity of varying precision. 

Either way, intrinsic value can be quantified as Net Present Value (NPV) based on Discounted Cash Flow (DCF) analysis.

Price is not value, neither in concept nor in quantity. Price is a market-generated quantity. 

• The confusing term "market value" is really market price. 
• The confusing term "fair market value" is really fair market price. 
• The fair market price is the price that equals the single quantity that best approximates investment value. 

The best point estimate of investment value is the mean of the distribution of values rather than the median of the distribution of values or the midpoint of the range of values.

http://www.numeraire.com/value.htm

INTRINSIC VALUE: THE RIGHT PRICE TO PAY

INTRINSIC VALUE

Both Warren Buffett and Benjamin Graham talk about the intrinsic value of a business, or a share in it.  That is, to buy a business, or a share in it, at a fair price. 

But, having regard to the possibility of error in calculating intrinsic value, the careful of investor should provide a margin of error by only buying the business, or shares, at a substantial discount to the intrinsic value.

Buffett is said to look for a 25 per cent discount, but who really knows?

DEFINING INTRINSIC VALUE

Buffett’s concept, in looking at intrinsic value, is that it values what can be taken out of the business. 

He has quoted investment guru John Burr Williams who defined value like this:

‘The value of any stock, bond or business today is determined by the cash inflows and outflows – discounted at an appropriate interest rate – that can be expected to occur during the remaining life of the asset.’ – The Theory of Investment Value.

The difference for Buffett in calculating the value of bonds and shares is that the investor knows the eventual price of the bond when it matures but has to guess the price of the share at some future date.

Graham's Valuation Formula

Investing is a multidimensional activity.

To cope with this complexity, investors have resorted to increasingly powerful computers that purport to capture the inter-relatedness of many variables.  But this approach tends to lose the most valuable input of all:  human intuition.

A far better solution for the investment process would be to "freeze" some variables so that analyses could focus on a reasonable number of factors.

Benjamin Graham's valuation formula provided all stock market investors with a critically important tool that freezes one of the key variables of the investment process to simplify the purchase decision.  By using Graham's formula, investors are freed to consider other important factors when evaluating a public company.


GRAHAM'S SIMPLE FORMULA
To calculate intrinsic value, multiply the earnings growth rate by 2 and add 8.5 to the total, then multiply that by the current earnings per share.

[8.5 + (2 x growth) ] x EPS = Intrinsic Value per share

1.  A no-growth company.   The company would have a P/E ratio of 8.5 (and an earnings yield of 12%), which is a fairly typical P/E for a mature company.

2.  An average-growing company.  Most analysts use a P/E range of 15 to 20 times earnings for the S&P 500.  This would translate into the average growth stock in the S&P 500 growing between the ranges of 3.25% to 5.75% (mean 4.5%).


3.  A faster-growing company.  A faster-growing stock growing at 10% will have a P/E ratio of 28.5.  This is fairly typical for the faster-growing companies in the S&P 500.


Two flaws in the valuation models.  All valuation models have flaws.

1.  Models such as Graham's value a company based solely on its earnings.  This leaves out the possible positive effects of non-operating assets or negative effects of non-operating liabilities..  That's why investors need to look beyond earnings and examine company balance sheets prior to purchase to look for non-operating assets and liabilities.

2.  A second flaw has to do with the potential competition from high interest rates.  Should the P/E ratio of stocks be immune to high interest rates?  Of course not.  Graham himself addressed this issue when he suggested that P/E ratios should be adjusted downward if long-term interest rates on AAA corporate bonds
exceeded 4.4%.  The revised Graham formula factors in the current yield to maturity on AAA corporate bonds in the calculation of a company's intrinsic value:

REVISED GRAHAM FORMULA
Intrinsic value per share = EPS x (8.5 + 2g) x 4.4 / y

where,
g = growth rate
y = yield on AAA corporate bonds


If the yields on AAA corporate bonds were to remain at 4.4%, then the original Graham model would remain intact.

If the yields on AAA corporate bonds increased to 6.6%, the P/E ratios would be reduced by 1/3 (4.4/6.6 = 2/3).

If the yields on AAA corporate bonds increased to 8.8%, the P/E ratios would be cut by 1/2.  Thus, the future value of all companies would be reduced by 50%, all things being equal.

For those who want to use Graham's amended model, some caution is warranted.  The model requires that the user forecast interest rates well into the future.  For an investor to rely on recent interest rates as an input to the model could be misleading.

Knowing and Setting the Upper Limits of Share Price

The P/E also can be used to establish a cap on intrinsic value.

While asset values set the lowest level for estimating intrinsic value, the P/E can serve as an upper limit.

The P/E ratio establishes the maximum amount an investor should pay for earnings.

• If the investor decides that the appropriate P/E ratio for a stock is 10, the share price paid should be no more than 10 times most recent yearly earnings.

It is not wrong to pay more, Graham and Dodd noted; it is that doing so enters the realm of speculation.  

• Since young, rapidly expanding companies generally trade at a P/E ratio of 20 to 25 or above, Graham usually avoided them, which was one reason he never invested in some new start up stocks, though he used and was impressed by their products early in his career.

Valuing Stocks - Absolute or Intrinsic Valuation

The two basic method of valuing stocks are;

• Relative valuation
• Absolute or Intrinsic valuation

Usually, absolute value is estimated by calculating the present value of the company's future free cash flows (cash flow minus capital spending).

The present value of that future-income stream is the theoretically correct value of the stock.

This method has its own difficulties and is less frequently used, but absolute value deserves a place in every investor's arsenal of valuation tools.

Calculating the absolute value of a stock isn't easy.  It is tough to forecast:

• how fast a company's free cash flow will grow, 
• how long they'll grow, and 
• at what rate they should be discounted back to the present.  

We estimate stocks's absolute values by inputting our estimates of a company's growth rate, profitability, and the efficiency with which it uses its assets into a discounted cash flow model.  The result is an analyst-driven estimate of a stock's fair value in absolute terms.

In an imperfect world, opting for the much easier - if less pure - method of relative valuation often makes sense.  

However, when the companies you are using as your benchmark are themselves mis-priced, relative valuation can lead you astray; without a reliable measurement tool, your measurements will be off.  That last point is crucial.

If the S&P 500, for example, is trading at a P/E ratio that is very high by historical standards, using it as a benchmark can be hazardous.  

A stock can appear much cheaper than the overall market and still be quite expensive in absolute terms.  So what's an investor to do?  

Unfortunately, there aren't any easy answers.  

The best way to approach stock valuation is by using many different methods, the same way you would if you were valuing a used car or a house.

Checking out what similar houses in a neighbourhood have sold for is akin to relative valuation, and walking through a house you're interested in - looking at the construction and quality of materials - is similar to intrinsic valuation.  

A judicious mix of both methods will serve you well.

Price Matters

Price matters in the stock market.

Just like you wouldn't run out and pay $10 a gallon for gasoline, why would you pay 100 times earnings for a company that is growing 15% a year?

Do you think the people who paid $212 for Yahoo YHOO in January 2000 are ever going to get their money back?

Yahoo's a good company, but it may take a very long time for the stock to get back to its old highs.

The same could be said of many other technology stocks and also even those technology companies with moats around them that got clobbered in post 2000.

Remember - the single greatest determinant of a company's return in your portfolio is the price you pay for its shares.

As important as it is to understand the quality of a company - its growth prospects, competitive position, and so forth - it is even more vital that you pay a fair price for the firm's shares.

You'll make a lot more money buying decent firms with low valuations than by paying premium prices for premium companies.  Why?  Because the future is uncertain, and low valuations leave a lot more room for error.

Objective of Fundamental Analysis: To determine a company's intrinsic value or its growth prospects.

Fundamental analysis is forward looking even though the data used is by and large historical.  


The objective of fundamental analysis is to determine:
- a company's intrinsic value, or
- its growth prospects.  


This intrinsic value can be compared to the current value of the company as measured by the share price.  If the shares are trading at less than the intrinsic value then the shares may be seen as good value.


Many people use fundamental analysis to select a company to invest in, and technical analysis to help make their buy and sell decisions.


The analysis of an individual company has two components:

-  The 'story' - what the company does, what its outlook is
-  The 'numbers' - the financials of the company, balance sheet and income statement and ratio analysis.

Always remember that behind all the numbers is a real business run by real people producing real goods and services, this is the part we call "the story".

It is unlikely that you will need to do the number crunching for every company, your time will be more profitably spent developing the company story.  Balance sheets and ratio analysis, both historical and forecast, can be obtained from either a full service or discount stockbroker.


Before trying to leap into the calculations behind fundamental analysis there aresome basic questions that are worth considering as a starting point:

1. Where is the growth in the company coming from?
2. Is the growth being achieved organically or through acquisition?
3. Is turnover keeping pace with the sector and with competitors?
4. What about the profit margin - is it growing?  Is it too high compared to competitors?  If it is too high then new competitors could enter on price reducing margins.  Low earnings could suggest control of the cost base has been lost or factors outside the company's control are squeezing margins.
5. To what extent do profits reflect one-off events?
6. Will profits be sustainable over the long term?

Companies are multidimensional.  For example, debt funding may have increased - this may be a positive move if the funds produce new productive assets.

Read more:

The objective of fundamental analysis is to determine a company's intrinsic value or its growth prospects.

VALUE STOCKS IN A WEAK MARKET

In the face of so much blood, why are investors not looking for value shares?  One could argue that market psychology drives the fear of more blood yet to come.  Timid investors wait for the bottom.  Value investors look for opportunities and jump in with an eye towards minimising losses.


----


Value investing takes many different forms, but all approaches aim to achieve the same objective - buying something for less than it is worth.

By Bob Kohut | 19.12.2011

You’ve heard this investing maxim near and dear to the hearts and minds of value investors everywhere – The Time to Buy is when there is blood in the streets.  British Banker Baron Rothschild supposedly made this observation after making a fortune buying in the midst of the panic preceding the Battle of Waterloo.

Today there is certainly blood in the streets, yet trading volumes in share markets everywhere are dwindling as buyers are not stepping in and following Rothschild’s advice.  Just how much blood is enough?

Here is a brief overview of the some recent bloody events:

•    The HSBC flash Chinese PMI (Purchasing Manager Index) for November was 48 – the lowest in 32 months.  The October PMI was 51. Values below 50 indicate contraction in the manufacturing sector.

•    The HSBC Flash China Manufacturing Output Index also hit a 32 month low at 46.7, down from 51.4 in October.

•    Share markets in Europe and the US collapsed as investors learned the catastrophic results of a German government bond auction. 

•    The United States may be headed for another credit downgrade as lawmakers failed to reach agreement on a long term deficit reduction plan.  There is already legislation in preparation to reverse some of the automatic cuts to the defense budget agreed on in the August deal.

•    France looks set to be downgraded this week, which will see its coveted AAA rating.

The inconvenient truth here is there is ample opportunity for more blood to be spilt before this is over.  Australians might take heart that of the three most troublesome areas – China, Europe, and the US – China is still in the best position to continue to deliver economic growth.

The unexpected drop in the HSBC indicators is troubling.  As you know, readings below 50 indicate contraction in economic activity.  The world has been expecting a slowdown in the expansion in China, not a contraction. 

However, other numbers provide a measure of comfort.  The Chinese government has been implementing policies to slow growth to help control what they see as a bigger problem – inflation.  In July of this year inflation reached a three year high of 6.5% but figures released in November show annual inflation fell to 5.5%.  This gives the government room to go back to policies to stimulate growth.

Europe is a catastrophe.  Germany is the Eurozone’s strongest economy and in a recent auction, bond investors responded to the government’s attempts to sell 6 billion Euros in ten year notes with a resounding yawn.  Only 60% of bonds up for auction were sold. It's tough to see a way out in the near future with France set to be downgraded, UK unemployment at a 17-year high, and Spanish house prices tumbling for the 14th consecutive quarter while unemployment soared to 23%.  

Perhaps the greatest concern is the possibility of yet another downgrade to the US credit rating.  The rating agencies have warned of this possibility if the US did not come up with a credible long term deficit reduction plan.  Not only did their politicians not do that, there is growing evidence some of the automatic cuts that were to take place in the event of a failure to reach agreement on a broader plan may be scaled back.  With the concern over China’s contraction and the Eurozone debt crisis, this US threat is still under the radar of many investors.

In the face of so much blood, why are investors not looking for value shares?  One could argue that market psychology drives the fear of more blood yet to come.  Timid investors wait for the bottom.  Value investors look for opportunities and jump in with an eye towards minimising losses.

Value investing takes many different forms, but all approaches aim to achieve the same objective – buying something for less than it is worth.  The difficulty with disciplined value investing is determining the true worth of a company, or its intrinsic value.  Many who consider themselves value investors use some shortcuts, including P/E and P/B ratios, dividend yield, ROE, PE/G, and Debt to Equity (Gearing) rather than the more complex discounted cash flow calculations.  

A P/E less than 10 with a P/EG less than .5 would be a potential value share for any value investing methodology.  The P/EG is a ratio popularised by Peter Lynch that expands on the P/E by using estimated future earnings growth in the denominator.  

We searched the ASX for companies with a minimum market cap of 500 million dollars that met those two criteria along with a minimum dividend yield of 2%.  Here are eight value candidates we found:

Company	Code	P/E	P/EG	ROE	Div Yield	Share Price
Air New Zealand	AIZ	7.96	.11	5.4%	9.1%	$0.67
Boart Longyear	BLY	9.36	.21	8.5%	2.6%	$3.03
Emeco Holdings	EHL	10.14	.46	9.2%	5.7%	$1.00
Fletcher Building	FBU	9.68	.43	9.8%	6.3%	$4.61
Henderson Group	HGG	8.61	.31	20.2%	6.8%	$1.59
Mount Gibson Iron	MGX	4.50	.11	19.8%	4.9%	$1.18
One Steel	OST	5.07	.49	5.3%	10.8%	$0.77
Telecom NZ	TEL	11.46	.64	16.7%	9.7%	$1.56

Where do we begin with this mass of numbers?  Some investors forget that each number is a part of a whole and instead gravitate towards their favorite metric.  Dividend yield is a major attraction of value investing as it provides a cushion in difficult markets.  On that measure alone, one might zero in on OST and TEL.

When you look at the whole forest rather than individual trees OST appears to be the most undervalued.  With a P/E of only 4.57 and a book value of $3.77 per share, it is trading at far below its book value with a share price of a meager $.77.

However, we have yet to look at another critical benchmark for value investing – debt.  While always a concern, we are now faced with the possibility of another global credit crunch which will put companies that rely heavily on short term borrowing and excessive long term debt at significant risk.  So let’s take a look at some debt and liquidity measures for our candidate shares:

	Quick Ratio	Current Ratio	Gearing 2011 - (2010)	Long Term Debt  ($m) 2011 - (2010)
AIZ	.64	.81	83.4% -- (68.6%)	851.5 - (731.2)
BLY	1.12	2.09	23.5% -- (14.5%)	243.5 - (147.7)
EHL	1.4	2.34	48.8% -- (48.8%)	290.5 - (298.9)
FBU	.92	1.78	54.2% -- (40.3%)	1,442 - (920.5)
HGG	.91	1.31	50.5% -- (64.5%)	272 - (325.9)
MGX	.90	3.69	3.9% -- (14.4%)	16.5 - (36.8)
OST	.75	1.89	41.8% -- (23.3%)	1,809 - (715.2)
TEL	.58	.67	90.7% -- (91.2%)	1,312 - (1,736)

   

In better times some value investors might overlook higher debt levels.  Right now that could be a big mistake.  Long term debt is frequently restructured to get better terms.  In the face of a credit freeze, that is not likely to remain a possibility.  High gearing indicates a company is using more of “other people’s money” to operate than its own money.  Liquidity ratios – the quick and the current – represent a company’s ability to convert assets into cash to meet short term liabilities.  Ratios below 1.0 could represent a problem.  If credit availability dries up, liquidity ratios become even more important.

All these indicators must be viewed in the context of the sector in which the company operates.  For example, TEL’s 90.7% gearing seems outrageous until you compare it to Australia’s Telstra, with a gearing ratio of 115.3%.

Another issue with debt and gearing is the trend.  Companies lever up and take on debt for expansion purposes and this is something you need to research.  In our table we showed the year over year difference in gearing and long term debt for each company.  You can see that OST more than doubled its debt and raised it gearing by about 40%.

On other measures, OST seems like it might be a bargain, but the bottom line is they are carrying too much debt.

Now let’s briefly review the other shares and see which ones shake out as potential bargains.

Air New Zealand (AIZ) is the premier air carrier in New Zealand.  Unfortunately, it operates in an industry now dominated by rabid competition and rising fuel costs.  Its debt position is no more than adequate and liquidity ratios under 1.0 could spell trouble.  Compared to some of the other shares in the table, the ROE is nothing to get excited about.  It does have a substantial dividend yield at 9.1%.  Investors interested in AIZ need to check the company’s dividend history and payout ratio.  Remember, yield is based on prior dividends paid with no guarantee of dividends going forward.  In short, there are probably better options.

Boart Longyear (BLY) provides equipment, drilling services, and other consumable products to the mining industry.  As such, they are at risk of a continued drop in commodity prices and a significant slowdown in China which will affect their customers – the miners.  Although their dividend payout ratio is low at 2.8%, dividend payout has been spotty, with no dividend paid for FY2009.  Although they modestly increased debt and gross gearing, they are still low enough to consider their balance sheet as reasonably strong.  BLY is a share that bears watching.

Emeco Holdings (EHL) is another mining services company, specialising in renting heavy earth moving equipment.  They are one of the few companies that actually reduced long term debt year over year although gearing remained the same.  Their 5.7% dividend yield beats most term deposit rates but the most compelling thing about EHL is the share price of $1.02 compared to its book value.  EHL is certainly a candidate for further review.

Fletcher Building (FBU) is a New Zealand based provider of building and construction materials.  Although it has an attractive dividend yield, it has minimal exposure outside New Zealand and Australia.  The company’s dividend payout has been gradually declining since the GFC.  Should the building and construction business deteriorate further, FBU faces significant risk.  There are other shares in our table that appaer to be better candidates.

Henderson Group (HGG) offers investment services in Europe, North America, and Asia.  They are based in London.  This company offers a substantial dividend of 6.8% and a solid ROE of 20%.  Many value investors look for an ROE of 15% minimum to qualify for their consideration.  However, considering the volatility of investment markets and the near certainty (in the opinion of many experts) the volatility will continue, the risks may be too great to look to invest in this company at this time.

Mount Gibson Iron (MGX) is a junior iron ore miner in Western Australia.  Although subject to the same risks from volatile commodity prices and a Chinese slowdown, their numbers are compelling.  The P/E of 4.50 and a P/EG of .11 are substantially better than the sector averages of 11.43 and .53.  An ROE performance of over 19% and a share price very close to book value per share make them a prime bargain bin candidate.  In addition, note they cut their long term debt more than in half and reduced gearing by approximately 70%.  Although the current dividend yield is modest, analysts forecast the dividend to double in FY2012 and FY2013.  MGX deserves a prime spot in the bargain bin.

Telecom NZ (TEL) was once upon a time a state run monopoly offering telecommunication services in New Zealand and parts of Australia.  Although they stand to benefit from the coming broadband explosion, regulatory changes and fierce competition pose significant risks going forward.  Although the dividend yield stands at a stunning 9.7%, dividend payouts have been decreasing over the past few years.  There are better candidates.

Finding value shares is not for the casual investor.  Today more and more investors seem to want someone to “give them a fish”, rather than “learning how to fish.”  Value investing is hard work.  We started with nine shares and boiled down to three – Boart Longyear, Emeco Holdings and Mount Gibson Iron.  Depending on your risk tolerance, you may want to include others.  However, to find real bargains you need to go beyond what we have uncovered here to look deeper into consistency of historical performance of a target share.  The greatest challenge is determining the real or intrinsic value of the company, not just the stated book value per share.  You need to know what goes into the accounting definition of “book.” 

http://www.thebull.com.au/articles/a/25014-value-stocks-in-a-weak-market.html