Issues to consider when valuing companies based upon fundamental analysis
By James Waggett
Fundamental analysis is the most widely used method of identifying & selecting stocks for investment used by professional fund managers. Unlike technical analysis, which involves analysing historical charts of price, volume, open interest etc, fundamental analysts attempt to value a company based on its earnings, prospects, management etc. They then derive Buy, Hold & Sell recommendations based on whether the share price is below, in line with, or above their valuation. The trouble is that the process is intrinsically subjective & effectively ends up with a theoretical valuation ie. what the analyst believes the company should be worth.
But there are a number of simple "fundamental" checks that anyone can apply to their stock selection process, which are particularly important for investors who take a long term, "Buy & Hold" approach.
(i) Sustainable Competitive Advantage
Most importantly, does the company have a competitive advantage that is sustainable over the long term ? This may be based on technology (eg. Computershare in share registries), or a dominant market position (eg. Telstra); it may be because they own a monopoly asset (eg. Hills Motorway owns the M4) or they may have capitalised on first mover advantage (eg. Brambles with Chep pallets globally) or because of great branding & marketing (eg. Harvey Norman) or simply because of the quality & depth of their management (eg. NAB or Lend Lease). Invariably these companies are highly rated because they are likely to show strong & consistent earnings growth, year on year.
(ii) Industry Structure
What is the structure of the industry? A monopoly, duopoly or oligopoly ? Generally, monopolies make excellent investments as they do not have competitors reducing returns (witness Telstra's monopolistic profits in local phone calls, until recently..). Stable duopolies can also make for excellent investments, such as the domestic brewing market shared between Fosters (via CUB) & Lion Nathan (via Tooheys), which generates great returns for both players - except during the occasional price war. Contrast this industry structure with, for example, the building materials sector where multiple players compete to produce commodity products (eg. bricks & tiles). No competitive advantage generally leads to lots of competition which leads to price competition & thus poor returns for each participant. Hardly an exciting investment environment: a low market rating will be the usual result.
(iii) Potential Market Size
What is the size of the potential market? Is it local or global? Clearly a company like Aristocrat, which produces gaming machines for the global market (with new opportunities emerging in Nevada & Californian as well as South Africa & Japan) is likely to provide much more growth (& hence a much higher rated share price) than a domestically focussed business (particularly if it has few export opportunities) such as Email, the manufacturer of white goods for the domestic market. Not surprisingly, the former will trade at a huge premium to the latter.
(iv) Size & Track Record
Companies grow by being successful over a number of years. Thus larger companies will have a longer track record. This instils confidence among investors who will consequently be prepared to pay a higher multiple than for a smaller rival with a shorter track record. This is because the larger company is less risky. But as you look at progressively smaller companies (& market capitalisation is a good measure) be aware that they will have shorter track records & be more risky. Hence, it is totally appropriate that in general, the smaller the company, the smaller the valuation multiple.
This article has looked at some of the important business characteristics used by fundamental analysts - the concepts of sustainable competitive advantage, industry structure, the size of a potential market & the company's size & track record. We have not yet begun to consider how we value these companies, indeed what measures or multiples to use. This will be the topic next month when we will consider earnings per share (eps), eps growth rates, price to earnings multiples (PEs) relative PEs, dividend yields, cashflow & discounted cash flows (DCFs)
Remember the old adage; "cash flow is real, profit can be an illusion".
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