Is fundamental analysis redundant Essay
Is fundamental analysis redundant
Shortly after the stock market crash in 1929, as the first batch of financial experts in the Great Wall, Benjamin Graham and David Dodd firstly mentioned the concept in a book called security analysis: Based on public information that intelligent investors are able to analyse securities and determine whether the current price of stocks and bonds is over or below their intrinsic value. The Critical thinking and strong logic make this theory become the foundation of nearly all investments theories in Wall Street. Warren Buffett, John Neff, Peter Lynch and other famous investors become the best practitioners in fundamental analysis. This essay will firstly introduce the related theories of fundamental analysis. Secondly, the essay will explain free cash flow model to equity valuation and the qualitative and quantitative factors of fundamental analysis. Thirdly, choosing a particular company analyses the relationships between the leading financial ratios and its stock price. Finally, indicating why financial ratios and free cash flow model cannot explain Berkshire Hathaway cooperation’s stock price changed during global financial crisis.
Theory Aasuumption & Metholody
Fundamental analysis which is based on analyzing the intrinsic value of securities, focuses on factors affecting the stock price and its trend and lets investors determine what type of securities they choose to buy and when to buy. (Lee and Swaminathan 1999, 8 )The basic assumption of fundamental analysis is that value investors believe that the market price is determined by its intrinsic value and the stock price can reflect its intrinsic value in the long term.
Cash flow model
Fundamental analysts use cash flow model, dividend model to roughly estimate a company’s intrinsic value. They assume that the stock price of the intrinsic value is its present value of the stream of expected cash flows and the selected reference values are based on generating the cash flow data. For example, using free cash flow model to measure intrinsic value, investors firstly assume the observed company can increase at constant rate and then choose the reference value based on a constant growth rate (g)to estimate free cash flow the next 10 years. Secondly, they calculate the present value of the 10-year cash flow based on the constantly discounted rate (k). Secondly, they estimate the terminal value P10=free cash flow*(1+g)/(k-g) and calculate its present value. Thirdly, they get the present value of the company and calculate pre- share value: equity value/numbers of shares. Rational investors can make well-informed investment decisions according to the relationship between market price and intrinsic value.
On the company level, fundamental analysis focused on two factors: qualitative and quantitative. Qualitative and quantitative analyses have a dialectical relationship. Both analyses should join together to analysis and inspect on a particular company. Although qualitative analysis is used for physical areas, with the usage to tackle non-financial information, it can be widely useful in business and finance fields.(kesh and Raja 2005, 167) The qualitative analysis of the company level is concerned with products and services, competitive advantage, management efficiency, corporate culture.
Advanced products can get increasing cash inflows and improve company value (Carter and Demissew 2008, 63) because booming demand for products and services can lead to a high reinvestment rate of the company, this creates additional wealth.( Madden 2007, 125) Competitive advantage can includes producing capacity and the efficiency of a company’s design and cost controlling better than the industry’s competitors. Generating a competitive advantage for a company will creates stakeholder value. (Vilanova, Lozano and Arenas 2009, 63) The improvement of management efficiency can lower operating costs and company culture can enhance corporate image, leading to improvement of company value.
The quantitative factors in fundamental analysis are based on a deep understanding of financial reports which is the process of identifying opportunities and threats from the company, so investors must be concerned with the balance sheet, cash flow statement and income statement analysis. Financial statements consist of all important historical information about the company’s operation management during a specific time period (quarterly, annually). All these information provide an overview of a company’s business activities and can help managers assess the company’s wellbeing. (Dayanandan 2010, 116)
Different users are interested in different areas of the financial statements. For example, investors and equity holders are concerned with expected earnings and dividends of the observed companies. Company’s executives usually focus on the company’s capacity. Therefore, based on historical reports, different users can get valuable information about what they concentrate on. Financial statement analysis includes selected data from financial statements to predict the company’s financial health.( Hagos and Pal 2010, 441) Applying these data from financial reports, such as profitability ratio, liquidity ratio, management efficiency ratio, debt ratio, market performance ratio analyses year by year to determine whether to buy or sell observed companies.
Based on analyzing financial statements, financial analysts are able to use profitability ratio, including gross margin, ROE to indicate how efficiently revenue is generated. The liquidity ratio such as current ratio, net working capital can be used to prove the firm’s ability to generate sufficient liquidity when needed and to meet short term obligations. For example, current ratio is an indicator as a rate of current assets to current liabilities. It measures the liquidity status of a company. With a higher current ratio over time, this company will be able to meet its current obligations and experience less financial risk.( Zaki, Bah and Rao 2011, 315) Table1 Sourced by Berkshire
Total asset turnover
Table 1 above shows the some figures provided by Berkshire corporation’s annual report from 2003 to 2006. During this period, the stock price has a significant increase from $67600 in Jan 2rd, 2003 to $109990 in Dec 1st, 2006. And from 2003 to 2006, Berkshire Hathaway Inc’s net worth is $13.6billion, $8.3billion, $5.6billion and 16.9billion respectively.
Graph1: Berkshire Hathaway(BRK) Inc’s stock price between 2003 and 2006
Sourced by yahoo finance
The increase of Net worth can indicate the stock price’s change during this period. The gain in net worth during 2003 was $13.6billion, which increased the per-share book value of its stock by 21% from $41727 to $50498. Because
of good quarterly reports and an annual report, the stock price reflected the company’s performance, rising from $67600 to $89490. However, between 2004 and 2005, the gain in net worth increased $8.3billion and $5.6billion. Although in 2004 Berkshire’s book-value gain of 10.5% fell short of the index’s 10.9% return, the net worth fell from $13.6billion to $8.3billion, leading to fluctuation of the stock price during 2004. In 2005, the net worth fell to $5.6 billion because hurricane caused loss worth of $34billion. And in the stock market, the price fluctuated and even slightly increased. However, the price reflected the company’s performance.
As a multi-business company, its main business-insurance company called GEICO improved its management efficiency at nearly 32% and warranty numbers increased by 26%. On the other hand, insurance float of BRK’s insurance company increased from 46 billion to 49 billion. Due to the capital cost rate of mostly 0% and improving competitiveness, its stock price rose sharply.
Financial ratios (price to book ratio and earnings per share ratio) measure share price compared to earnings, book value per share and indicate whether the market overvalues, undervalues and appropriately values the firm’ shares. Managers use to assess investors’ perceptions of future prospects. Some investors invest in stock market based on analyzing financial statements.
Table2 shows mainly the relationship between the book value and stock price. Financial analysts are willing to use book value to measure the stock price. From the table 2 above, the book value of the Berkshire Hathaway increases from $14426 in 1995to $70281 in 2006 and the company’s stock movements, rising from $31900 in 1995 to $110050 in 2006. In addition to particular years, these two charts reflect clearly whether a short term or a long term, the trend of the book value and stock price is roughly the same. In the long term, the growth rate of the net worth is a useful indicator to justify intrinsic value. From 1995 to 2006, the net worth of Berkshire Hathaway’s net worth increased from $5.3billion to $16.9billion, more than 3.18 times growth during the period. Stock price had increased 3.44 times with book value 4.87 times. Although 1n 1999, the net worth fell to 0.358billion, in the long term, this company still had a significant increase in its stock market performance.
Analysts also can apply activity ratios such as total asset turnover ratio and average payment ratio period to measure management effectiveness in managing its assets and to determine whether the investment in particular asset categories is too high or too low and also find out the efficiency or speed in converting accounts to sales or cash. (Dayanandan 2010, 114)Debt ratios such as debt to equity ratio and debt ratio can indicate financial leverage and the apparent financial risk assumed by the firm’s equity holders.
Graph2 Dow Jones industrial index
Sourced by yahoo finance
Graph2 shows the change of Dow Jones industrial index before, during and after global financial crisis. The global financial crisis started in 2007 because the burst of housing bubble caused credit crisis especially in the debt markets.( McCarthy, Solomonand Mihalekl 2012, 1277 ) the stock market highly violated between 2007 and 2009. For example, in United States, the stock market increased to the peak in October 2007 with the Dow Jones Industrial Average about 14,000. After that duration, the Dow Jones dropped sharply from 12,000 in August 2008 to 6,600 in March 2009. After 2009, there is significant increase until now, rising to 14,929.
Company- Berkshire Hatchaways
Berkshire’s core business for insurance business includes the property casualty reinsurance and special class insurance company. For the past 25 years, this company has increasingly strong capital and little debt, for shareholders to create the value of more than 25% growth on average every year. Table 3 shows analysis ratios and stock price from 2006 to 2012. Table3
Total asset turnover
Sourced by Berkshire
Graph3 Berkshire’s stock price between 2006 and 2012
Sourced by yahoo finance
The gain in net worth during 2006 was $13.6billion, which increased the per-share book value of its stock by 18.4% to $109990. In 2007, the net worth is 12.3billion, which increased the per-share book value of its stock by 11% to $141600. However, in 2008, the stock price fell to $96600, and then there is an increasing trend from 2009 to 2012.
Total assets turnover ratio
Total assets turnover ratio measures the management efficiency of the firm in managing its total assets to generate sales. A high ratio suggests greater efficiency. Figures shown in table3, the total assets turnover ratio during global crisis had slight change between 0.37 and 0.40. However, the stock price changed sharply, so the stock price can not reflect the stability of this ratio. ROE indicates the rate of return realized by a firm’s shareholders on their investments and uses as an indicator for the company’s operation.
Return on equity (ROE)
Return on equity (ROE) is the best indicator to learn how much money a company is making for its investors and measurement of the company’s operations. (Dayanandan 2010, 117) However, ROE is also sensitive to leverage. Assuming that proceeds from debt financing can be invested at a return greater than the borrowing rate, ROE will increase with greater amounts of leverage. From 2007 to 2008, the debt to equity ratio increased by 13.7%, from 1.24 to 1.41. However, ROE rate fell sharply from 10.9% to 4.6%. Although ROE overreact to debt change, Berkshire’s fundamental did not change in 2008. Most of Berkshire’s business is affected by the economic significant downward in 2009. However, its manufacturing services and retail generated a lot of cash flow and continued to consolidate their market competitive advantage. Berkshire’s two most important businesses: business insurance and utilities also had a good growth rate. These businesses produced a large amount of business profits in 2008.
P/E ratio is a common approach used by security analysts. In practice, investors usually use expected P/E ratio for the following year and analyse whether the stock price is overvalued or undervalued on the basis. P/E ratio indicates that a stock of its P/E rate over 30 is more likely to be overpriced. The P/E ratio in 2007 and 2008 is 13.8 and 38 respectively and the stock price during the period time of 2007 and 2008 is $141600 and $96600. The change of stock price is overreact to the pre-share earnings.
P/B ratio gives some idea of whether an investor is paying too much for what would be left if the company went bankrupt immediately. From 2006 to 2009, P/B ratio increased or decreased had no direct correspondence with the stock price. However, to most companies, the book value is always lower than the stock price. Because most companies have intangible assets such as brand name, specialized skills，product pricing power. These factors can not reflect in the balance sheet, but the long term trend of the market value is similar with book value. It seems that when P/B ratio increases, the gap between book value and stock price increases. On the other hand, the gap shows investors are willing to hold the stock due to its intangible assets.
Cash flow model
All these financial ratios cannot explain what happened in 2008 and using cash flow model to estimate the stock price also cannot explain this situation. Because investors assume the company can increase at constant rate. Although they use long-term GDP growth rate to reduce the risk of assessing value, this growth rate cannot explain and predict what happened during the investing period. They also use CAPM to measure discounted rate given by the risk-free interest rate plus a risk premium. The formula is ki=Rf+(Rm-Rf)βi. However, βsometimes cannot estimate risk between the market and stock. For example, a company’s market value increases from 10billion t0 20billion is less than market value of the company from 10billion to 3billion. If the company still operate well, from the market side, the risk of buying a company of the market value of 20billion is less than buying the same company of its market value of 3billion.
Therefore, during global financial crisis, fundamental analysis was useless. It is clear that during some periods the stock price is overvalued or undervalued significantly from its intrinsic value, leading to highly volatility of market price. Any market volatility is considered as irrational performances, so these market valuations caused by behavioral finance which do not have impacts on the company’s assets valuations and operations. (Adams, Armitage and FitzGerald 2012, 157).
In the long term, the trend of the stock price is similar to the trend of its intrinsic value. On the other hand, in the short term, market price is influenced and fluctuated by political, economic, psychological factors, so market price is always undervalued or overvalued, but it is fluctuating around the intrinsic value. Some research show that sometimes earnings information cannot react to the stock market simultaneously and all the public financial information pose a gradual influence on the stock market for a while. During global financial crisis, the stock price sharply fluctuated because of financial behavior. Debt crisis caused by housing loan had a significant impact on people’s confidence. Trader’s low confidence let them make decisions irrationally.
1. Lee, C.M.C. and Swaminathan, B. 1999. “Valuing the Dow: A bottom-up approach.” Financial Analysts Journal 55 (5): 4-23.
2. Kesh, Someswar. and Raja, M. K. 2005. “Development of a qualitative reasoning model for financial forecasting.” Information Management & Computer Security 13 (2): 167-179.
3. Carter, T. and Demissew, D.E. 2008. “Value innovation management and discounted cash flow.” Management Decision 46(1): 58-76.
4. Madden, B.J. 2007. “Guidepost to Wealth Creation: Value-Relevant Track Records.” Journal of Applied Finance 17 (2): 119-130.
5. Vilanova, M., Lozano, J.M. and Arenas, D. 2009. “Exploring the Nature of the Relationship Between CSR and Competitiveness.”Journal of Business Ethics 87: 57-69.
6. Dayanandan, R. 2010. “Working Capital Management for Sustainable Cooperatives.” Global Business and Management Research 2(1): 102-124.
7. Hagos, T.M. and Pal, G. 2010. “The means of analysis and evaluation for corporate performances. “Annales Universitatis Apulensis : Series Oeconomica 12 (1): 438-449.
8. Zaki, E., Bah, R. and Rao, A. 2011. “Assessing probabilities of financial distress of banks in UAE.” International Journal of Managerial Finance 7 (3): 304-320.
9. McCarthy, Mary., Solomon, P., and Mihalek, Paul. 2012. “Financial Crisis During 2007 And 2008: Efficient Markets Or Human Behavior?” Journal of Applied Business Research 28 (6): 1275-1281.
10. Adams, A., Armitage, S. and FitzGerald, A. 2012. “An analysis of stock market volatility.” Annals of Actuarial Science 6（1）：153-170.