In the world of investing there are two methods of strategically analyzing a stock to purchase: Fundamental Analysis and Technical Analysis. These two methods can be used simultaneously to decide which company to buy and when to buy.
Fundamental analysis takes a holistic approach of the company to arrive at an intrinsic value. It can be broken down into two methodologies: Qualitative analysis and Quantitative analysis, in our methods of valuing a company we use both approaches. Qualitative is centered around aspects of the company that cannot be measured such as future prospects. Quantitative analysis is largely accounting-based and analyses the company’s financial statements.
Technical analysis is concerned strictly with price date, and the stock’s supply and demand dynamics. Technical analysis is based on price and volume data alone and not the underlying company.
Another factor worth considering is the efficient market hypothesis. This is a belief that all information that can be known about a stock is already factored into the share price, thus the price is always reasonable.
After reading all this and understanding these three hypotheses: Fundamental analysis, Technical analysis, and the efficient market hypothesis it can be difficult to establish which to peruse in your investing techniques. At Prophet, we believe in all three. We believe that the market is mostly efficient and the majority of the time stock prices are proportional to underlying value. This is why we take large positions in index-tracking ETFs such as VAS and IVV. In saying this we believe from time to time there are opportunities where inefficiencies occur and by using technical analysis and fundamental analysis simultaneously we can profit by taking positions in temporarily undervalued companies.
What is Fundamental Analysis?
Fundamental analysis is a method of creating an intrinsic value (fair value) based on related economic and financial factors. These factors include both macroeconomic factors such as interest rates and the state of the economy as well as microeconomic factors such as a companies management. Fundamental analysis is broken into two subgroups;
- Quantitative – related to information that can be shown in numbers and amounts.
- Qualitative – relating to the nature or standard of something, rather than to its quantity.
These two subgroups should be considered together when arriving at an intrinsic value. The qualitative method is an excellent approach to arrive at an intrinsic value by analyzing the underlying financials of the company. As a result of this blue-chip companies are easy to value, whereas small growth companies are almost always considered overvalued based on quantitative methods. This is why it is important to consider techniques both together.
When valuing a company using qualitative analysis there can be an endless list of factors impacting the future of a company. We evaluate four main groups;
- Economic Moat
- Future industry outlook and disruption
The term economic moat was coined by the legendary warren buffet. It is a term used to describe a business’s competitive advantage. It is a reference to how a moat protects a castle from seige. Investopedia defines it as ‘a distinct advantage a company has over its competitors which allows it to protect its market share and profitability.’
“In business, I look for economic castles protected by unbreachable ‘moats’”. Warren Buffett
There are five types of generally accepted economic moats;
- Low-cost production; Companies that can keep their prices low can maintain market share and discourage competition
- High switching costs; Customers and suppliers might be less likely to change companies or providers if the move will incur monetary costs, time delays, or extra effort. e.g. banks and power providers
- Network effects; network effect happens when the “value of a good or service grows” as its used by existing and new customers e.g. Amazon is an excellent example
- Intangible assets; Brand identity, patents, and government licenses are examples of intangible assets. e.g. think Nike or Coca-Cola as an excellent brand and think of the government regulation surrounding gamble and the moat this creates for gambling companies.
- Efficient scale. Companies that have a natural monopoly – or operate in markets or industries where there are few rivals
One thing to consider about an economic moat is most times they are largely priced into a stock share price as they often relate to profits. For example, Coca-Cola has an excellent brand and due to that sells more products and creates more profits. As such these factors will often be indirectly accounted for in Quantitate Analysis but it can be helpful to identify businesses with and without these moats.
There is no set way to judge a company based on its management and over time the results will speak for themselves. As such, just like an economic moat, good management will deliver sold profits over time which will be reflected in Quantitative Analysis.
When a business is under new management this may be a time to evaluate the management and attempt to forecast the outlook for the business. Consider educational and professional backgrounds. One of the most important factors is their experience in the industry. Their reputation is also key. What goals has the management set out for the company?
we also consider insider trading. Is management buying or selling large amounts of shares? Sudden large selling by management for no apparent reason may hint that management believes the company is overvalued or peaked at that point in time.
It is also important to have a look at the compensation of the management. Good leaders are priceless, however, if management is being paid exorbitant fees for poor performance they may be taking advantage of the company. This is why we are a big fan of performance-based compensation.
One case study of management is the effect that Elon Musk has had on tesla. Another example is the impact of insider selling had on A2 Milk in 2019.
Regulation is around predicting the risks or benefits that could be afforded to a company based on government or industry regulation. There are many forms this can have including the possible regulation of the BNPL space and what this could involve, the government support of zero-emission cars, the government regulation on high polluting industries. Regulatory factors could be positive and negative.
As these are often speculation it can be hard to imagine how or if they would impact a business. It is more appropriate to draw conclusions once the regulations are announced or apparent rather than trying to guess ahead of time.
Future Industry Outlook and Disruption
This factor is very similar to regulation but also accounts for non-government factors. For example, it may be about the development of the internet and the impact this has had on e-commerce and standard brick-and-mortar stores. The disruption of Blockbuster by online streaming platforms. Or the way uber has revolutionized ridesharing and disrupted the taxi industry.
Investopedia defines Quantitative Analysis as “A technique that uses mathematical and statistical modeling, measurement, and research to understand behavior. Quantitative analysis represent a given reality in terms of a numerical value.”
The key source of information used for Quantitative Analysis is widely available for all listed companies within their annual statements. Annual statements can be downloaded from company announcements via the ASX website, Market Index, or most good brokerage sites. Key information in these statements is; Chairman’s reports, director’s reports, and the financial statements.
The financial statements are made up of four documents; Balance sheet, Income statement, Changes in equity, and Cash-flow statement. All of which are important for Quantitative analysis. These documents outline all financial aspects of the business including profits, revenues, assets, and liabilities. By summarizing this information we can analyze key aspects;
Price Earnings Ratio (PE) and EPS
EPS or earnings per share is the portion of the profit earned for every ordinary share on issue. It is calculated by taking the net profit and dividing it by the number of ordinary shares, it is measured in cents per share.
On its own EPS means very little to investors, but we like to have a look at the trend of EPS over time and ensure that it is increasing rather than remaining stagnant or falling. Keep in mind that EPS can be altered by reducing the number of shares on issue if shares are repurchased.
EPS is also used to calculate the Price-earnings ratio or PE, this will then account for the overall share price allowing comparison between companies. PE is one of the most commonly referenced statistics in fundamental analysis.
The PE ratio can be interpreted as the amount you pay for $1 in company profits, for example, if the PE is 10, it means investors are willing to pay $10 for every $1 in company profits. It is also the number of years it would take for your purchase to be recovered by earnings (If PE remains constant). If a company was currently trading at a P/E multiple of 20x, the interpretation is that an investor is willing to pay $20 for $1 of current earnings. PE can also be known as earnings or price multiples.
A company with a high PE could be seen as overvalued or that investors are expected large growth in the future. In comparison, a company with a low PE could be seen as undervalued or may have poor investor sediment. A company with no profits will not have a PE. In the below graph we can see that the average PE for the ASX all ordinaries is around 15.
PE can be calculated with previous figures (trailing PE) or future figures (Forward PE). From the above graph, we see a massive peak in PE due to the COVID crash which dramatically impacted company earnings, since then share prices have recovered but profits are yet to return.
The earnings yield is the inverse of the PE ratio and reveals the same information. The earnings yield refers to the earnings per share for the most recent 12-month period divided by the current market price per share. It shows the percentage of a company’s earnings per share. This graph shows the average earnings yields of the ASX all ordinaries.
Price-Earnings to Growth Ratio (PEG)
The PEG ratio accounts for the PE ratio as well as the growth of a companies EPS over time. it is calculated as the PE ratio divided by the EPS growth over a set time period. The PEG ratio is considered to be an indicator of a stock’s true value, and similar to the P/E ratio, a lower PEG may indicate that a stock is undervalued.
Dividend Per Share (DPS) and Dividend Yield
The DPS is the value of dividends the company pays out in a 12-month period divided by the shares on issue. It can be expressed as gross (accounting for the franking credit) or net. Market Index has an excellent calculator to assist with DPS.
The dividend yield takes the DPS and divides it by the current share price. This then calculates the yield or return an investor can expect from dividends in this company. It can again be expressed as gross yield or net yield.
It is important to note that the dividend yield could be influenced by sudden drops in share price that would inflate the dividend yield. Also, the dividend yield may be impacted if the DPS is abnormally high in a 12-month period due to special dividends. When assessing a companies Dividend yield we ensure that it hasn’t been influenced by fluctuation in share prices and we also ensure the company has a reliable history of steady or growing dividends proportional to their profits.
Dividend Payout Ratio
The dividend payout ratio is the percentage of profits the company pays out to shareholders in comparison to total profits. Relatively high payout ratios may leave companies with insufficient capital to grow. High ratios may also mean that management believes paying out profits is better for shareholders than reinvesting in the company. Generally speaking, we like companies with a payout ratio of 80% or less. In the case of growth and technology companies, the payout ratio should be significantly less.
The book value is the net assets of a business divided by the number of shares on issue. As such it can be thought of if the company was liquidated today it would be the investors receive for each share. The net assets are given as total assets minus total liabilities. Book value is measured in cents per share.
Return on Equity
Return on equity (ROE) is a measure of financial performance calculated by dividing net income by shareholders’ equity. Because shareholders’ equity is equal to a company’s assets minus its debt, ROE is considered the return on net assets. ROE measures how many dollars of profit are generated for each dollar of shareholder’s equity. ROE is a metric of how well the company utilizes its equity to generate profits. ROE should be compared between similar companies.
The debt-to-equity (D/E) is calculated by adding outstanding long and short-term debt and dividing it by the book value of shareholders’ equity. It can be used to ensure that any liabilities are well covered by assets. We avoid companies with excess debt.
Cash On hand
Cash on hand is a simple measure that we quickly look at. We just want to ensure that a company has sufficient liquid cash to pay current liabilities and take advantage of future opportunities without the need to raise capital.
Fudamental Analysis: Prophet’s Take
Fundamental Analysis is a great starting point for identifying investment opportunities. Used in conjunction with the efficient market hypothesis and technical analysis it can form a decent insight into a companies value.
However, it is important to acknowledge that the analysis can be manipulated and biased based on emotions and should be performed objectively comparing values between multiple companies, sectors, and the market as a whole.