💲Intro to Investments Unit 6 – Fundamental Analysis & Equity Management

What's Fundamental Analysis?

• Involves analyzing a company's financial statements, business model, and competitive environment to determine its intrinsic value
• Aims to identify undervalued or overvalued securities by assessing a company's financial health, growth prospects, and risk factors
• Assumes that a company's stock price may not always reflect its true value due to market inefficiencies or short-term fluctuations
• Considers both quantitative factors (financial ratios, earnings growth) and qualitative factors (management quality, competitive advantages)
• Contrasts with technical analysis, which focuses on historical price and volume data to predict future price movements
• Requires a thorough understanding of accounting principles, financial statement analysis, and industry-specific knowledge
• Can be used for long-term investment decisions, as it focuses on a company's fundamental strengths and weaknesses

Key Financial Statements

• Balance Sheet provides a snapshot of a company's financial position at a specific point in time
  • Lists a company's assets (what it owns), liabilities (what it owes), and shareholders' equity (the difference between assets and liabilities)
  • Helps investors assess a company's liquidity, solvency, and financial leverage
• Income Statement presents a company's revenues, expenses, and net income over a specific period (usually a quarter or a year)
  • Allows investors to evaluate a company's profitability, operating efficiency, and growth trends
  • Key metrics include gross profit margin, operating profit margin, and net profit margin
• Cash Flow Statement tracks the inflows and outflows of cash during a specific period
  • Categorizes cash flows into operating activities (cash generated from core business operations), investing activities (cash used for long-term investments), and financing activities (cash raised or returned to investors and creditors)
  • Helps investors assess a company's ability to generate cash, fund its operations, and meet its financial obligations
• Statement of Shareholders' Equity shows the changes in a company's equity over a specific period
  • Includes transactions such as the issuance or repurchase of shares, dividend payments, and changes in retained earnings
  • Provides insight into a company's capital structure and how it manages its equity

Important Financial Ratios

• Liquidity Ratios measure a company's ability to meet its short-term obligations
  • Current Ratio = Current Assets / Current Liabilities
  • Quick Ratio (or Acid-Test Ratio) = (Current Assets - Inventories) / Current Liabilities
• Profitability Ratios assess a company's ability to generate profits relative to its revenue, assets, or equity
  • Gross Profit Margin = Gross Profit / Revenue
  • Operating Profit Margin = Operating Profit / Revenue
  • Net Profit Margin = Net Income / Revenue
  • Return on Assets (ROA) = Net Income / Total Assets
  • Return on Equity (ROE) = Net Income / Shareholders' Equity
• Solvency Ratios evaluate a company's ability to meet its long-term debt obligations
  • Debt-to-Equity Ratio = Total Debt / Shareholders' Equity
  • Interest Coverage Ratio = Earnings Before Interest and Taxes (EBIT) / Interest Expense
• Efficiency Ratios measure how effectively a company uses its assets and manages its liabilities
  • Inventory Turnover = Cost of Goods Sold / Average Inventory
  • Receivables Turnover = Revenue / Average Accounts Receivable
  • Asset Turnover = Revenue / Total Assets
• Valuation Ratios help investors determine the relative value of a company's stock
  • Price-to-Earnings (P/E) Ratio = Stock Price / Earnings per Share (EPS)
  • Price-to-Book (P/B) Ratio = Stock Price / Book Value per Share
  • Dividend Yield = Annual Dividend per Share / Stock Price

Valuation Models

• Discounted Cash Flow (DCF) Model estimates the intrinsic value of a company by discounting its future cash flows to their present value
  • Requires forecasting a company's future cash flows and determining an appropriate discount rate (usually the weighted average cost of capital, or WACC)
  • Sensitive to assumptions about growth rates, terminal value, and discount rate
• Dividend Discount Model (DDM) values a company based on the present value of its expected future dividend payments
  • Assumes that a stock's value is equal to the sum of its future dividend payments, discounted back to their present value
  • Suitable for companies with stable and predictable dividend growth rates
• Relative Valuation compares a company's valuation multiples (P/E, P/B, EV/EBITDA) to those of its peers or industry averages
  • Helps identify whether a company is undervalued or overvalued relative to similar companies
  • Requires selecting appropriate peer groups and adjusting for differences in growth, profitability, and risk
• Asset-Based Valuation estimates a company's value based on the fair market value of its assets minus its liabilities
  • Useful for companies with significant tangible assets (real estate, natural resources) or in industries with high asset intensity
  • May not fully capture the value of intangible assets (brands, intellectual property) or future growth potential

Industry Analysis

• Involves examining the competitive dynamics, growth prospects, and regulatory environment of a specific industry
• Porter's Five Forces Framework assesses the competitive intensity and attractiveness of an industry based on five factors:
  • Threat of new entrants
  • Bargaining power of suppliers
  • Bargaining power of buyers
  • Threat of substitute products or services
  • Rivalry among existing competitors
• Industry life cycle analysis helps investors understand the stage of development and growth potential of an industry
  • Stages include embryonic, growth, shakeout, maturity, and decline
  • Each stage has implications for industry growth rates, competitive intensity, and investment opportunities
• Regulatory and technological changes can significantly impact an industry's competitive landscape and growth prospects
  • Regulatory changes may create barriers to entry, alter competitive dynamics, or impact profitability
  • Technological disruptions can render existing products or business models obsolete and create new growth opportunities

Economic Factors

• Macroeconomic conditions can significantly impact a company's financial performance and stock price
• Economic growth, as measured by gross domestic product (GDP), influences consumer spending, corporate profits, and stock market returns
  • Expanding economies generally benefit companies through increased demand for goods and services
  • Recessionary environments may lead to reduced consumer spending and corporate investment
• Inflation, the rate at which prices for goods and services rise, affects interest rates, consumer purchasing power, and company profitability
  • High inflation erodes the value of fixed-income investments and may pressure companies to raise prices or absorb higher costs
  • Central banks may raise interest rates to combat inflation, which can increase borrowing costs and slow economic growth
• Interest rates impact the cost of borrowing for companies and consumers, as well as the relative attractiveness of different asset classes
  • Rising interest rates can negatively affect companies with high debt levels or capital-intensive businesses
  • Falling interest rates may stimulate borrowing and economic activity, benefiting cyclical industries
• Currency fluctuations can impact the competitiveness of exporters and the profitability of multinational corporations
  • A weaker domestic currency makes exports more competitive but increases the cost of imported inputs
  • A stronger domestic currency may negatively affect exporters but benefit companies that rely on imported goods

Equity Management Strategies

• Active management involves selecting individual stocks or sectors based on fundamental analysis, with the goal of outperforming a benchmark index
  • Relies on the ability of portfolio managers to identify mispriced securities and generate alpha (excess returns)
  • Requires significant research, expertise, and resources, leading to higher management fees
• Passive management aims to match the performance of a benchmark index by holding a portfolio that replicates the index's composition
  • Based on the efficient market hypothesis, which suggests that stock prices reflect all available information and it is difficult to consistently outperform the market
  • Offers lower costs, greater transparency, and better tax efficiency compared to active management
• Value investing focuses on identifying undervalued companies with strong fundamentals and holding them for the long term
  • Seeks to buy stocks trading at a discount to their intrinsic value, based on metrics such as P/E, P/B, or dividend yield
  • Requires patience and a contrarian mindset, as undervalued stocks may remain out of favor for extended periods
• Growth investing targets companies with high earnings growth potential, often in rapidly expanding industries
  • Prioritizes revenue and earnings growth over valuation metrics, assuming that strong growth will justify higher valuations
  • May be more volatile and sensitive to market sentiment than value investing
• Income investing emphasizes generating steady income through dividends or interest payments
  • Suitable for investors seeking regular cash flows and lower volatility than the broader market
  • Focuses on companies with stable and growing dividends, such as mature, well-established firms in defensive sectors

Putting It All Together

• Fundamental analysis provides a comprehensive framework for evaluating the intrinsic value and investment potential of a company
• Investors should consider a company's financial statements, key ratios, and valuation metrics in the context of its industry and the broader economic environment
• Qualitative factors, such as management quality, competitive advantages, and corporate governance, can also significantly impact a company's long-term prospects
• Developing a thorough understanding of a company's business model, growth drivers, and risk factors is essential for making informed investment decisions
• Regularly monitoring and reassessing investments based on changes in company fundamentals, industry dynamics, or macroeconomic conditions is crucial for long-term success
• Diversification across sectors, industries, and geographies can help mitigate risk and smooth portfolio returns
• Combining fundamental analysis with other investment approaches, such as technical analysis or quantitative strategies, may provide a more comprehensive view of investment opportunities
• Maintaining a long-term perspective and avoiding emotional decision-making are key to successful equity investing, as short-term market fluctuations can obscure underlying company fundamentals