4 rules for Fundamental Analysis of Stocks or Stock Valuation

Fundamental Analysis of stocks is a topic on which realms and realms of paper have been dedicated.

One such book, “A Random Walk Down Wall Street” by Burton Malkiel talks about four important determinants or parameters that can be used for the fundamental analysis of stocks.

If  used properly, these four inputs can be used to arrive at a proper stock valuation. The author says that the  fundamentalist is heavily dependant on these four parameters. Let us look at them now.

The expected growth rate

Simply put, the expected growth rate of a company translates into a higher stock valuation. However, the growth rate is never consistent and as the years roll by, a company finds it difficult to grow at the same rate.

The time period of this constant growth is also an important factor that cannot be neglected – a company growing at 9% for 10 years will be more valued than a company growing at the same rate for 5 years, provided all other parameters are equal. So the first rule is :

Rule 1 :

• A rational investor should be willing to pay a higher price for a share the larger the growth rate of dividends and earnings.

Corollary to Rule 1 :

• A rational investor should be willing to pay a higher price for a share the longer an extraordinary growth rate is expected to last.

When translated in Price-Earnings (P/E) multiples instead of stock price, it is found that a high P/E ratio is associated with high growth rates of companies.

The expected dividend pay-out

This rule reads thus : if all things are equal, a higher dividend payout translates into a higher value of a stock. What is to be noted here is that a higher dividend does not necessarily translate into a rich value of the stock – for example, a company could pay dividends but have a poor growth rate, such a company would not be a good value buy.

The words “all things being equal” are thus important. So the second rule is :

Rule 2 :

• A rational investor should be willing to pay a higher price for a share, other things being equal, the larger the proportion of a company’s earnings that is paid out in cash dividends.

The degree of risk

Risk plays an important role in stock valuation. Stocks of large cap firms are less risky; anything which is less riskly is more in demand from risk-averse investors and so stocks of  large-cap firms go for more premium than small cap companies.

Risk could be defined as the degree by which the price of the stock swings relative to the market – the more this swing, the more riskier the stock. The third rule is :

Rule 3  :

• A rational (and risk averse) investor should be willing to pay a higher price for a share, other things being equal, the less risky the company’s stock.

The level of market interest rates

Before you invest in stocks, you would look elsewhere to see whether you can get risk-free returns of the same percentage that your stock is offering. If it does, why would you invest in the stock which carries some degree of risk at all?

So for an investor to be lured to invest in a stock, there should not exist another avenue which offers a higher rate of return.

If fixed-income instruments were to offer low interest rates, everyone would invest in the stock market to get more returns.

Conversely, if the returns from some debt instrument is more than what the stock market has to offer, investors will pull out their monies from the market and invest into debt.

So the last rule is:

Rule 4 :

• A rational investor should be willing to pay a higher price for a share, other things being equal, the lower the  interest rates.

Caveats to the 4 rules

While these four rules help in the analysis of stocks and provide some basis for stock prices, some caveats need to be kept in mind as well.

Caveat 1 : Expectations about the future cannot be proven in the present.

Predicting future growth in terms of earning and dividends is the  most difficult job and one cannot really ever be sure  about the growth estimate and its duration. You need to be an economist and a stock market expert to do this job.

Caveat 2 : Precise figures cannot be calculated from un-determined data.

Predicting future growth depends on a lot of factors which can be changed by the fundamental analyst to arrive at a stock value that he thinks is correct. For example, expected future growth rate can be played around with to calculate the value of a share.

If the fundamental analyst does not like what he arrives at, he can tweak the growth rate till he arrives at a value which he thinks is right or which he likes more ! As you can see, fundamental analysis is not fool-proof.

Conclusion

In principle, if applied intelligently, the four rules along with the caveats can reveal what a stock is actually worth. However, it must be noted that fundamental analysis is a science and it has been proved to both work in some cases and fail in others. This is best left to professionals who understand the intricacies of the stock market and stock valuation.