What You'll Learn
- The 12 guiding principles of fundamental analysis
- Thoughts on growth and valuation
- 7 further accounting principles
- 6 valuation principles to apply
There's two parts to this post, but it's aims to provide a good basic framework for analysis and valuation.
I keep coming back to a great book that I finished in just a few days.
The book is the fifth edition of Stephen Penman's Financial Statement Analysis and Security Valuation and Accounting for Value
I highly recommend these books to anyone who wants to learn more about financial statement analysis and security analysis.
In the first chapter Penman shares a few tenets, or “guiding principles,” that he keeps coming back to throughout the whole book.
These guiding principles are not ground breaking. In fact, I'd be more surprised if you haven't come across these. But these are still the foundational principles, and as with all sound principles they are worth remembering – and sharing.
Keep them close in mind when venturing out into the market space.
12 Tenets of Sound Fundamental Analysis
Here is some of the wisdom that I've paraphrased based on my practice of fundamental analysis over the years.
- One does not buy a stock, one buys a business
- When buying a business, know the business
- Value depends on the business model, the strategy
- Good firms can be bad buys
- Price is what you pay, value is what you get
- Part of the risk in investing is the risk of paying too much for a stock
- Ignore information at your peril
- Don't mix what you know with speculation
- Anchor a valuation on what you know rather than speculation
- Beware of paying too much for growth
- When calculating value to challenge the stock price, beware of using price in the calculation
- Stick to your beliefs and be patient; prices gravitate to fundamentals, but that can take some time
I do want to make a short mention for #10 and #11 in particular.
#10 Beware of Paying Too Much for Growth
As a simple example where a P/E ratio indicates the market's expectation of future earnings growth, a P/E of 131 for Blackberry (BBRY) is high by any standard.
The fundamentalist questions whether the market is forecasting too much earnings growth. Specifically, point 10 warns you about getting too excited—too speculative—about future growth.
Fundamentalists see speculation about growth as one of the prime reasons for the overpricing of stocks and the emergence of price bubbles.
A valuation method needs to build in protection against paying too much for growth.
A sound valuation method challenges the market's speculation about growth. A reason why reverse valuation methods like a reverse DCF is highly useful to determine the level of speculation and expectation built into a stock.
#11 When Calculating Value to Challenge the Stock Price, Beware of Using Price in the Calculation
Price is what you pay and value is what you get.
So Point 11 warns against referring to the market price when you are calculating value.
If you do so, you are clearly being circular and have ruined the ability of your analysis to challenge prices. Yet analysts allow prices to enter in subtle ways. An analyst who increases her earnings forecast because stock prices have increased—and then applies a valuation multiple to those earnings—commits that error.
It is so easy to do when there is excitement about a stock, for there is a temptation to justify the price.
But the analyst may be joining a chain letter.
Reminds me of a quick example when the iPad first launched and AAPL shares were trading at $380 pre-split, an analyst forecast earnings per share of $28.82 for fiscal year 2011.
Considerably higher than other analysts.
Fair enough – if you can justify the number.
But the analyst also published a price target of $548 per share and, accordingly, issued a buy recommendation. To get this price, the analyst multiplied his 2011 earnings estimate by Apple's average P/E over the last three years of 19.
See the problem?
The analyst is pricing earnings on the basis of the market's pricing of earnings, but if that pricing is incorrect it's already building mispricing into the calculation.
Price was used to challenge the market price, rather than to use the intrinsic value to compare against the stock price.
What you don't think about is how this particular analyst also compounded the speculation with a forecast. Put another way, if a P/E of 19 represents a mispricing, he contributed to the perpetuation of the mispricing.
No wonder bubbles form. The fundamentalist takes care to apply methods that establish the intrinsic P/E ratio without reference to market prices.
Stephen Penman's Valuation Principles
“If you read Graham's The Intelligent Investor— and one is advised to do so— there is not much in the way of techniques or calculations. Rather, Graham instructs us how to think about investing. He writes as a sage, he offers wisdom. Investing, he says, is first about attitude and approach rather than technique.”
?Stephen Penman, Accounting for Value
In the book the author provides several practical principles to follow for accounting and valuation. It's a technical and very practical book so if you are unsure of what I'm outlining below, definitely grab a copy to improve your fundamental analysis skills.
Improving Fundamental Analysis with Accounting Principles
- Future book value = Current book value + Future Earnings?Future Dividends.
- Accrual accounting brings the future forward in time, anticipating future cash flows.
- a. Leverage increases earnings growth.
b. Leverage increases profitability (the return on common equity).
- Book rate-of-return is an accounting measure determined by how one accounts for book value. It is not necessarily a measure of real business profitability. Accounting that keeps book values lower generates higher book rates-of-return and higher residual earnings.
- Conservative accounting with investment growth induces growth in residual income.
- Under uncertainty, (conservative) accounting defers the recognition of earnings to the future until the uncertainty has been resolved, and the deferral of earnings results in earnings growth.
- The stock return is always equal to earnings plus the change in the price over book value for the earnings period.
Improving Fundamental Analysis with Valuation Principles
- To get a handle on value, think first of what the book value is likely to be in the future.
- If one forecasts that the rate-of-return on book value will be equal to the required rate-of-return, the asset must be worth its book value.
- To get a handle on value, think first of what the book value is likely to be in the future and, second, what the rate-of-return on that book value is likely to be.
- Growth that is valued does not come from earnings growth but from residual earnings growth.
- a. Leverage reduces the P/E ratio from the enterprise P/E if the enterprise P/E is less than 1/Borrowing cost.
b. Leverage increases the P/E ratio over the enterprise price-to-book if the enterprise price-to-book is greater than 1.0.
- Accounting for value produces valuations that correct for the accounting employed; as earnings can be generated by accounting methods only by reducing book value, the appropriate valuation is preserved by employing book value and earnings together.