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Ignore the Ups and Downs of the Market and Use Fundamental Analysis Instead
Posted By Ron On December 1, 2011 @ 12:40 PM In Investing,Personal Finance,Retirement,Tips & Techniques | Comments Disabled
The world’s investment markets are notorious for their wild swings up and down, but savvy investors know the underlying fundamentals of each business (stock) they buy and they analyze them before purchasing (fundamental analysis). Great investors know WHY they bought and what made the company appealing to them. They know the conditions of the industries they invest  in, the management team running the show, and the company’s long-term prospects for the future. They know the numbers, they know at what share price they’ll buy more … and at what has to change for them to sell their shares.
Analyzing a stock’s fundamentals simply means examining a company’s financial numbers to uncover any prospects for the company’s future and to size up its stock value. Your goal when conducting fundamental analysis is to find stocks whose share prices are below where the market should be pricing them. Since markets aren’t always as “efficient” as many experts would have you believe, using fundamental analysis to uncover these undervalued gems can result in superior returns. Another strong benefit of fundamental analysis is that it removes much of the emotion associated with valuing a business and allows investors to make a rational buying or selling decision.
Rarely will you ever find a business with perfect numbers in every category you examine … I know I haven’t! But by actually taking the time to learn about a company’s financial numbers and then determining the market value of it’s stock, I can then decide to buy only when I have a large margin of safety. That is, I buy only when the stock is priced at less than half of what I determine it’s value should be.
Generally, when investors speak of a company’s fundamentals, they’re referring to the company’s financial well-being, as determined by three principle factors:
Data about a company’s fundamentals is easy to find, as every publicly traded company is required to report it quarterly to the SEC. One good place to start is online. I like to use Yahoo! Finance (finance.yahoo.com ).
Once you’ve gathered this data, you can use a variety of simple statistics and ratios to assess a company’s fundamentals and determine whether the company’s stock is worth buying. The most commonly used ratios and statistics are:
The best way to understand how to calculate and use these ratios and statistics is through an example. The fictitious company in the example below, Big Red Bullfighting Capes, Inc. (stock symbol “TORO”), has financial numbers as follows:
Let’s analyze TORO’s fundamentals and the value of its stock:
You’ll need a few more pieces of data to determine the stock’s value:
You’ll also need to be able to use and understand Future Value and Present Value calculations. These are both pretty easy to use with a spreadsheet.
I take the analyst’s ten year growth rate and the current EPS and calculate what the EPS should be in ten years. When I calculate that number and then compare it to the P/E ratio for the industry, I’m able to get a rough idea what the stock price should be.
TORO example: The future value of a $10 EPS over the next ten years at a 10% growth rate = $25.94. Many investors conducting fundamental analysis use a P/E ratio of double the growth rate so in our case it would be 20. With that P/E ratio, the stock should be valued at $518.80 in ten years. Now we switch to present value calculations and since I want to achieve a rate of return of 15%, the present value of $518.80 is $128.24. That’s what I value this stock to be today based on the numbers I have available.
To buy or not to buy? I wouldn’t buy this stock unless it’s price dropped to $64.12. Why do I use a 50% margin of safety? I may have made a mistake in my calculations somewhere or I may just have a streak of bad luck! Also, because valuation is an imprecise art, the future is unpredictable, and humans do make mistakes, a large margin of safety insures that I don’t lose money.
In the end, fundamental analysis is much more reliable that other measures in determining whether a business is worthy of my hard earned dollars as an investment. What method or methods do YOU use to make your investing decisions?
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