Samples of Fundamental Analysis
Dec 1, 2020 · 7 min read

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

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

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

Operating Margin Ratio

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

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

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

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

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

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

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.


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