Fundamental analysis: valuing a company like an investor

In depth12 min read · 13 sources

Fundamental analysis estimates the value of a company from its business, its figures and its prospects, and compares it with the share price. It looks at a stock the way an investor does: as a stake in a business, not as a price ticker. Here you will learn about business models and economic moats, financial statements and metrics, work through a DCF model and the Gordon model step by step, and find out what research knows about value, quality and the limits of the method.

What fundamental analysis is

Fundamental analysis asks what a company is worth, measured by the money it will bring its owners in the future. It compares this intrinsic value with the share price; if the price is well below it, the stock is considered undervalued. The foundational work is “Security Analysis” by Benjamin Graham and David Dodd (Graham and Dodd 2008), first published in 1934. Its counterpart is technical analysis, which only evaluates prices and trading volumes.

Top-down starts with the economy, interest rates and sectors, bottom-up with the individual company. Whether searching for undervalued stocks is worthwhile for private investors is covered in the article stock picking.

Business model and economic moat

Before any figure comes the question of how a company makes money and why that should continue: does it depend on a few customers? How much pricing power does it have? How much capital does its growth require? How strongly does demand fluctuate with the economy?

An economic moat is a durable competitive advantage that keeps competitors at bay. Typical sources are:

• Network effects: a product becomes more valuable the more people use it, such as a marketplace.
• Switching costs: switching would be expensive or risky for customers, as with enterprise software.
• Cost advantages: through scale, location or processes.
• Intangible assets: brands, patents, licenses and regulatory approvals.

A moat becomes measurable through the return on capital, ROIC (return on invested capital): if it is well above the cost of capital for many years, something is evidently protecting earnings from competition.

Reading the financial statements

The annual financial statements consist of three statements that belong together:

• Income statement: revenue, costs and profit for a year in stages, namely gross profit (revenue minus cost of sales), EBITDA (earnings before interest, taxes, depreciation and amortization), EBIT (operating profit) and net income. Margins show how much of revenue is left over.
• Balance sheet: assets and how they are financed on a reporting date (equity, financial debt, pension provisions, goodwill from acquisitions).
• Cash flow statement: payments rather than accounting entries, split into operating, investing and financing activities. Operating cash flow minus capital expenditure roughly gives the free cash flow, i.e. the money that can flow to providers of equity and debt.

Profit contains estimates and accruals: revenue that has not yet been paid, provisions, depreciation periods. If profit grows much faster than operating cash flow over several years, it is worth taking a closer look. This is exactly the pattern that Sloan (1996) examined.

Metrics: P/E, P/B, EV/EBITDA and more

Metrics condense the financial statements. Example Inc. is fictitious: revenue of $1,200 million, EBITDA of $180 million, EBIT of $145 million, interest of $20 million, 28% tax, net income of $90 million, equity of $600 million, net financial debt of $400 million, 50 million shares at $25 each, a dividend of $0.90 and expected free cash flow of $100 million.

Enterprise value (EV) is market capitalization plus net financial debt; it goes with figures before interest such as EBITDA, while the P/E goes with net income after interest. No metric is good or bad in itself: a P/E of 14 means something different for a utility than for a growing software company. Compare within the industry and with the company's own history. At Example Inc., the ROIC of 10.4% is above the cost of capital of 8.0% (next section): it creates value.

Valuation with the DCF model

The discounted cash flow model (DCF) is at the heart of company valuation (Damodaran 2012): a company's value is the sum of its future free cash flows, discounted at the cost of capital. Because nobody can forecast cash flows forever, you model a few years in detail and capture the rest in a terminal value.

The weighted average cost of capital (WACC) blends shareholders' required return with the after-tax cost of debt. The cost of equity is usually estimated with the CAPM. For Example Inc.: a risk-free rate of 2.5%, a beta of 1.1 and a market risk premium of 6.0% give 2.5% + 1.1 × 6.0% = 9.1%. Debt costs 5.0%, or 3.6% after 28% tax. With target financing of 80% equity and 20% debt, the WACC is 0.8 × 9.1% + 0.2 × 3.6% = 8.0%.

How sensitive is the result? Just one percentage point more or less in the WACC or growth shifts the value per share considerably:

The range runs from $22.23 to $49.13. At a share price of $25, the stock is clearly undervalued or slightly overvalued, depending on the assumptions. More than three quarters of the value lies in the terminal value, i.e. in the period after year 5. A DCF is therefore less a determination of value than a translation of assumptions into a price.

Dividend discounting and the Gordon model

For mature companies with steady payouts, a simpler model is often enough: the share price is the present value of all future dividends. If the dividend grows permanently at a constant rate, the result is the formula of the Gordon growth model, named after Gordon (1959):

Conversely, you can read from a market price what growth is priced in. A P/E of 25 with a 60% payout and an 8% required return requires g = 8% − 0.6 / 25 = 5.6% a year, forever. Such reverse calculations (reverse DCF) are often more honest than a point estimate, because they show everything that has to go right. For the market as a whole, the Shiller P/E follows the same logic; the gap between its earnings yield and safe investments gives an estimate of the equity risk premium.

For advanced readers: Ohlson's residual income model

The residual income model starts from book value. If the clean surplus condition holds (book value only changes through earnings and distributions), the present value of dividends can be rewritten as book value plus the present value of residual income, i.e. earnings above the cost of capital. Ohlson (1995) turned this into a model that links market value to book values, earnings and dividends.

• P/B and returns: a P/B above 1 is only justified if the return on equity stays above the cost of equity for good. A P/B below 1 prices in that the company destroys value.
• Growth requires investment: perpetual growth in the terminal value requires reinvestment, which reduces free cash flow; roughly, growth = reinvestment rate × ROIC.
• Forecast errors: according to Chan et al. (2003), long-term earnings growth is hardly more persistent than chance would suggest and is barely predictable even with many variables; analysts' growth forecasts are too optimistic.

Value investing and the margin of safety

Value investing buys stocks that are cheap relative to earnings, book value or cash flow. In “The Intelligent Investor” (Graham 2003), Graham made the margin of safety the central concept: only buy if the price is so far below the estimated value that even errors in your own estimate can be absorbed. For Example Inc., the margin would be 1 − 25 / 31.22 = 19.9%. The table shows, however, that a WACC just one percentage point higher almost wipes it out.

Cheap is not the same as undervalued: if the business is shrinking, a low P/E is justified. This is called a value trap. Many value investors therefore also pay attention to quality: high returns on capital, a solid balance sheet, steady cash flows.

What the research shows

• Value premium: Fama and French (1992) showed that size and the book-to-market ratio capture the differences in average stock returns, whereas beta hardly does. This gave rise to the HML factor (see Fama-French factors and value premium).
• Financial statement signals: according to Piotroski (2000), a score based on nine financial statement signals, the F-Score, separates winners from losers among cheaply valued stocks. It raised a value investor's average return by at least 7.5% a year; a long/short strategy returned 23% a year from 1976 to 1996. The benefit was concentrated in small and medium-sized, thinly traded firms not followed by analysts.
• Accruals: Sloan (1996) found that earnings with a high share of accruals persist less and that prices only reflect this with a delay (accrual anomaly). A strategy that buys stocks with low accruals and short-sells those with high accruals returned 10.4% size-adjusted in the first year in the 1962 to 1991 sample and was positive in 28 of 30 years.
• Profitability: according to Novy-Marx (2013), gross profits relative to total assets predict returns about as well as the book-to-market ratio; profitable firms deliver higher returns despite higher valuations (profitability premium).
• Quality: Asness et al. (2019) define quality as profitability, growth and safety. Quality stocks are on average only slightly more expensive; a factor of high versus low quality (quality minus junk) delivered significant risk-adjusted returns in the US and in 24 countries.
• Value's weakness: according to Fama and French (2021), the value premium was much lower in the second half of the 1963 to 2019 period; because of the high volatility, however, it cannot be shown that the expected premium has also fallen. Arnott et al. (2021) put value's shortfall against growth stocks from 2007 to mid-2020 at a drawdown of 55% and explain it with unrecognized intangible assets and a sharply widened valuation gap.

Whether such premiums are a reward for risk or the result of investor errors is disputed. More on this under efficient market hypothesis.

Limitations and common mistakes

• Earnings management: accounting choices and estimates (depreciation periods, provisions, revenue recognition, capitalized development costs) shift profits between years. Compare profit and operating cash flow over several years.
• Intangible assets: research, software and brands are often missing from the balance sheet. P/B and classic value metrics make such firms look more expensive than they are.
• Terminal value and forecasts: a few assumptions determine most of the value. If you do not vary them, you are talking yourself into a false sense of certainty.
• Information in the price: financial statement figures are public and analyzed by many professionals; an edge is more likely to come from better judgment about the future.
• Hindsight: backtests of metric-based strategies need the data as they were known at the time (point-in-time data) and also the firms that later disappeared (survivorship bias).

This article explains methods; it is not investment advice and not a recommendation of individual stocks.

How Portfolio Lab calculates it

Portfolio Lab does not calculate DCF valuations of individual companies and does not hold balance sheet metrics. The ideas of fundamental analysis appear in the app at three other levels:

• Market valuation: the Valuation page shows the Shiller P/E of the S&P 500 since 1881 and uses a regression to estimate what real returns similar valuations delivered over the following 5, 10 or 15 years (methodology).
• Factors: the Factors page regresses funds or a portfolio on factors following Fama and French, including value (HML) and, in the five-factor model, profitability (RMW), for eight regions. This lets you see whether a value fund really invests that way. Factor statistics also show the premiums by decade; there you can check for yourself how value fared in the 2010s (methodology).
• Securities database: the screener on the Securities page also finds stocks by name, ISIN or ticker and filters by type and exchange; a ranking sorts the results by price history metrics such as return, Sharpe ratio or alpha. It does not filter by P/E or free cash flow.

You calculate your own valuation outside the app; in the Backtest, you can see how the stock would have changed the risk and return of your portfolio.

This article explains a method; it is not investment or tax advice. Worked examples are simplified and rounded. All terms in the glossary.