Fundamental Price Modeling


  A person not familiar with the basic facts of economics and finance could assume that the price of a company’s stock reflects, by a large amount, the actual value of the company. However, this notion cannot hold true in a free market where supply and demand are, eventually, the factors that affect market prices. But is the financial data of a company irrelevant to its stock price and useless for an investor? Presumably it is not, as there are people who use Fundamental Analysis to determine investment opportunities, and Fundamental Analysis is a method that utilizes the economic fundamentals of a company.

In the following paragraphs we take a look at the most common tools and terms used in fundamental analysis.

Financial Statements


There are three basic quarterly or annual financial statements that each company publishes:

• Balance Sheet
Shows the overall financial status of a company at a given point of time.

• Income Statement
Shows the revenues, expenses, profit over a one year period.

• Cash Flow Statement
Similar to the income statement; but does not include depreciation, amortization etc.

A short description of each one follows.


Income statement

The income statement provides the most basic financial info on a company i.e. revenues, expenses and profit during a quarter or a whole year. In effect, it reflects the performance of the company during that period of time. It can generally be described by the following formula:

Revenue – All Expenses = Income

Key points:

• Revenue
The amount of money the company received during the period in question. This is considered by many the most important piece of information about a company.

• Expenses

- Cost of Revenue
Shows the production costs that brought the revenue. It includes cost of raw material, worker salary etc.

- Operating Expenses
Costs of R & D and administration, including marketing, are under operating expenses.

- Interest Expenses & Tax
All interest (e.g. from loans) and tax paid by the company.

- Non-recurring Events
Usually one-time expenses that don’t fall in the other categories.

• Net Income
The actual profit of the company after all expenses are deducted from revenue.


Balance Sheet

It is called a “balance sheet” because it has to show that the basic company figures balance out. That is:

Liabilities + Stockholder Equity = Assets

The Balance Sheet is a snapshot of a company’s financial status at a given point in time. One balance sheet cannot give information about growth rate etc, but can show if a company is healthy, or owes too much.

Key points:

• Assets (Depreciated Values)

- Current Assets
Company assets that can be quickly converted to cash. Apart from actual cash, unsold inventory
is an example of current assets.

- Non-current Assets
Other assets, like equipment, property etc, that cannot be easily converted to cash.

• Liabilities

- Current Liabilities
Short term liabilities. For example bills that have to be paid before the next statement.

- Non-current liabilities
It is favorable for a company to have Non-Current liabilities than Current ones, as this would not always mean bad health status for a company.

• Stockholder Equity (Internal Value)
After subtracting the liabilities from the assets, stockholder equity reflects the current value of
the company that stockholders own.

• Net Tangible Assets (Book Value)
By subtracting intangible assets and goodwill from the equity, we get the book value of the
company, which shows how much we would sell all tangible assets for (buildings, inventory,
materials etc).


Cash Flow Statement

The cache flow statement is similar to the income statement; however it does not include non cache charges and focuses on cache earnings before depreciation or amortization.

Key points:

• Cash Flows from Operating Activities
All the money that the company made or lost through its normal operating activities.

• Cash Flows from Investing Activities
Investing activities can include any third party bonds/shares/funds bought or sold, as well as
property & infrastructure investments.

• Cash Flows from Financing Activities
Financing activities include borrowing or loaning money and money spent or received through
company stocks / bonds.


Metrics & Ratios


The data collected from the financial statements can be used to calculate some more useful measures, like:

• Debt / Asset ratio
A high ratio means a highly leveraged company.

• Current ratio = current assets / total current liabilities
A value of less than 1 shows liquidity problems.

• Working Capital = current assets - current liabilities
The Working Capital is a measure of a company’s liquidity.

• Turnover Ratio = Goods sold / inventory
An indication of how quickly a company can sell its inventory. A higher number among similar industry companies is favorable.

• Margins
Margins are generally earnings as % of sales. A useful measure is the Net Margins which is net income divided by net sales, and a low value is a sign of a struggling company.

• EPS (Earnings per share) = Profit / number of shares
It is a rather straightforward calculation. However, the more useful prospective EPS growth rate is calculated through the consensus forecast earnings for the following year.

• P/E ratio (Price to earnings)
More useful than EPS to compare companies, it is the price per share divided by EPS and makes sense only for a company that has (positive) earnings. For a company with loss there is the PSR (price to sales ratio).

• PEG ratio (Prospective earnings growth)
PEG is calculated by dividing a company’s expected annual percentage earnings growth taking by it’s stock’s P/E ratio.

• P/B ratio (Price to book) = market cap / book value.
Shows how much more than the book value of the company the market is willing to pay.

• ROE (Return on Equity) / ROA (Return on Assets)
ROE is an indication of a company’s efficiency. It is calculated by taking a company's after-tax income and dividing by its book value (or the Total Assets in the case of the ROA).

• Dividend Yield & Dividend payout ratio
These measures show how much pay in dividends an investor can expect from his stock and the percentage of company earnings given as dividends respectively.




This part of the TextBiz analysis is inspired by the CSE691 Fundamental Analysis project by D. Kechagias which can be found [here].