Samples of Fundamental Analysis

Warren Buffett, considered by many to be the most successful investor of all time, learned his craft from the Father of Fundamental Analysis, Benjamin Graham. The author of “The Intelligent Investor” and co-author with David Dodd of “Security Analysis” noted that “A stock is not just a ticker symbol or an electronic blip; it is an ownership interest in an actual business, with an underlying value that does not depend on its share price.”

Graham believed that investors could calculate the intrinsic value of a company by analyzing past financial results. His analytical approach contrasted with the typical investment practices of the time that focused on stock price movements and short-term profits. Graham recognized that emotions — fear and greed — drive market values in the immediate present, but prices ultimately reflect a company’s intrinsic value.

It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price.

Warren Buffett

Graham’s strategy, copied by Buffett later, was to buy companies whose real value was higher than its market value and holding them until market value exceeding intrinsic value. “Individuals who cannot master their emotions are ill-suited to profit from the investment process.“ Graham advocated an investment philosophy based on information, analysis, and logic.

Fundamental Analysis Tools

Since Graham’s time, the tools of fundamental analysis have expanded and become more sophisticated. In 1950, the Securities and Exchange Commission (SEC) reported 2,573. By 1996, the number had almost tripled to 7,500. By 2018, due to mergers and acquisitions, the number has fallen to 4.400. Over the years, companies have expanded across industry lines to global markets. Simultaneously, the breadth and volume of operating information have exploded, complicating analysis and comparisons between companies.

Fortunately, many of the concepts developed by Graham remain valid today, simplifying the decision to invest by the results of tried-and-true analytical techniques. The following examples have stood the test of time and should be in the toolbox of every investor seeking to find the best values in the market today. Examples from Apple Inc. Form 10-K for the Fiscal Year Ended September 28, 2019, follow the various formulas and are distinguished by blue. All $ figures are in millions.

Ratio Analysis

Analysts make specific ratio calculations to evaluate a company’s liquidity, operational efficiency, and profitability using its financial statements (balance sheet, income statement, and cash flow statement). Once calculated, the ratios are compared to other companies in the same and different industries to determine the company’s relative position related to others.

Several ratios are useful to compare different aspects of a company. Three of the more common are:

Operating Margin Ratio

The operating margin ratio compares the operating income of a company to its net sales to determine operating efficiency:

Operating margin ratio = Operating income / Net sales
Apple Operating margin ratio = $63,930 / $260,174
Apple Operating margin ratio = 24.5%

Return on Equity Ratio

The return on equity ratio measures how efficiently a company is using its equity to generate profit:

Return on equity ratio = Net income / Shareholder’s equity

Apple Return on equity ratio = $55,256 / $90,488
Apple Return on equity ratio = 61.0%

Asset Turnover Rate

The asset turnover ratio measures a company’s ability to generate sales from assets:

Asset turnover ratio = Net sales / Average total assets

Apple Asset turnover ratio = Net sales /(( 2018 t.a. — 2019 t.a.)/2) + 2018 t.a Apple Asset turnover ratio = $260,174/ (($365,725 — $338,516)/2) + $338,516
Apple Asset turnover ratio = .738 times

Dividend Discount Model

Financial theory explains that a company’s value is the sum of current and future cash flows in the form of dividends discounted by a reasonable risk-adjusted rate. The formula is relatively simple, excluding determining the risk-adjusted return rate.

The risk-free rate is typically considered the yield of Treasury bonds with a duration equal to the expected investment term less inflation. At the end of 2019, the ten-year yield was 1.92%. According to the Bureau of Labor Statistics (BLS), the inflation rate at the end of 2019 was 1.8%, producing a risk-free rate of return of 0.12% (1.92% — 1.8%). Using the Treynor Ratio (risk-free rate/β of Apple (APPL) stock) produces a risk-adjusted rate of 0.09% (0.12%/1.35). Apple’s latest annual dividend for the latest 12 months ended November 9, 2020, is $0.82 per share.

Using the Dividend Discount Model, the intrinsic value of Apple is $91.11 ($0.82/.009). A current market value suggests that Apple’s market value ($120.00 per share) is about one-third greater than its intrinsic value by this calculation.

Since Graham authored his book, investor goals changed, transitioning from focusing on current return through dividends to stock price appreciation and capital gains. Corporate management’s mantra became high growth and retaining high cash balances to fund growth. Today, about one-third of public companies pay dividends.

The Dividend Discount model is not applicable to growth companies that pay little or no dividends. Using the model requires the analyst to guess if, when, and how much dividends might be paid in the future, a sketchy practice contrary to a fundamental analysis philosophy. Despite the model’s difficulties, the underlying theory — a company today is worth the discounted cash flows of the future — remains valid.

Cash Flow Discount Model

Another popular method to value companies is by discounting future cash flows to their present value. Many analysts prefer to use cash flow, believing it to be more difficult to manipulate by CFOs’ timing and allocation decisions. The disadvantages of the model are its necessary reliance on projections and its simplicity. Like all models, the value of the analysis depends on the quality of the information. Determining correct information is difficult for analysts as companies have grown diverse and more complicated, producing financial reports that condense data in the reports while adding voluminous footnotes of explanation.
Analysts have modified the model in the search for accuracy. For example, many versions substitute the weighted average cost of capital (WACC) for the discount rate. Others use sophisticated definitions of cash flow, including Free Cash Flow to the Firm (FCFF) and Free Cash Flow to Equity (FCFE). While useful for professional analysts supported by elaborate IT systems and knowledgeable mathematicians. They are generally beyond the ability of an average investor working from home with a PC.

The following formula is the basic Cash Flow Discount model and an example of the calculation of Apple Inc intrinsic value. Since Apple’s 17.2 billion shares are selling around $120 each, the company’s market value exceeds $2 trillion, more than twice the present value of the company with annual growth in earnings of 20%. Based on the model, Apple would need average growth above 40% per year to justify the market valuation.

Graham Formula

Graham’s original valuation was a formula of earnings per share, PE multiple, and growth rate (V = EPS x (8.5 + 2 times the growth rate). The formula was amended in his book The Intelligent Investor to include the risk-free interest rate and the average AA-rated Corporate Bond rate. The “8.5” number in the formula refers to the PE for a typical company, while the 4.4 was considered the risk-free interest rate.

Looking at Apple stock with the original formula, the intrinsic value would be $367.24 per share. Unfortunately, the high earnings per share combined with the growth and the extraordinary low interest rates. The new Graham model is modified to lower the PE and reduce the impact of projected growth. Nevertheless, the calculations produce intrinsic values well above Apple’s market value of $120 per share, indicating the stock would be an acceptable purchase.

Final Thoughts

Improved communication networks provide real-time, online data for sophisticated math and statistical models to slice, dice, and display in a myriad of views, many of which are unintelligible to the average investor. An additional complication is that analytical measures often produce contrary advice, whether due to wrong data, analyst error, or invalid use.

In the last decade, more and more information -gathering and mathematical calculation — the heavy, generally dreary work of analysis — has been transferred to computers augmented with Artificial Intelligence. Keeping abreast of the market and continually analyzing one’s current and possible investments can quickly become a full-time chore. Fortunately, non-professional investors can access the same services for a low cost through independent providers like wealthX.

Note: The calculations using Apple Inc. stock are intended as examples only and do not constitute a recommendation to buy or sell or investment advice.