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Recently I was reading about different fundamental analysis approaches, and specifically about Value Investing, as proposed by Ben Graham and David Dodd. This approach describes a strategy which based on finding "under-priced" securities using some for of fundamental analysis. This allows filtering out "good" companies which are more likely to gain profit on a long term.

I know that fundamental analysis could be based on global parameters such as the following, focusing on a whole industry sector or area:

  • GDP growth rates
  • Inflation
  • Interest rates
  • Exchange rates
  • Productivity
  • Energy prices, etc...

As well as focusing on a specific company and analyzing:

  • The Income Statement
  • The Balance Sheet
  • The Cash Flow Statement

So I wonder where can I find a step-by step procedure, which describes the process of security evaluation(or as referred in Ben Graham theory - intrinsic value) using the above data? Specifically, I would like to see some practical guidance as how to use this data.

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  • If a set-in-stone procedure like this were to exist, I presume each and every trading firm would use it, thus removing any potential for arbitrage.
    – John Bensin
    Apr 23, 2013 at 11:09
  • @JohnBensin Thank you for your comment. Are you saying that all those people who use fundamentals to analyze their securities, are doing it differently? I mean everyone just makes different decisions based on the same balance sheets and cash flow statements? Isn't the whole idea of fundamental analysis (compared to technical) is the ability to evaluate a real price depending on real numbers (or at least choose healthy financially company)? And if everybody are interpreting the same data differently then how is it different from technical analysis which considered by many to be just gambling ?
    – Eugene S
    Apr 23, 2013 at 12:22
  • See Dilip Sarwate's answer; he's making pretty much the exact point I was.
    – John Bensin
    Apr 23, 2013 at 20:50

2 Answers 2

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Your items

  • The Income Statement
  • The Balance Sheet
  • The Cash Flow Statement

are presumably available to any analyst, but some of the items in

  • GDP growth rates
  • Inflation
  • Interest rates
  • Exchange rates
  • Productivity
  • Energy prices, etc...

might not be assessed in the same way by different analysts. For example, should general measures of inflation be used (and if so, which ones? e.g. changes in CPI or chained CPI?) or should one take into account how inflation affects or will affect consumers of the specific products manufactured by the company being considered? In short, as John Bensin's comment points out, there is no set-in-stone procedure with fixed inputs that every analyst uses, and so different analysts might reach different conclusions as to how much a particular company stock is under-valued, and make recommendations of different strengths as to whether the stock should be purchased.

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  • +1 You summarized my thoughts in a better fashion than I would have. I would also add that sector-specific factors are important as well, because (strangely) not every analyst takes them into account. For example, I've seen analyst reports on the biotech industry that draw comparisons to Silicon Valley tech companies but completely ignore info about clinical trials, etc. It's as if they saw the term "technology" and applied a blanket strategy.
    – John Bensin
    Apr 23, 2013 at 20:49
  • Thanks a lot for your answer! I didn't realize that this is how it works. For some reason I thought it to be a more "built-in" procedure. Anyway, if I disregard the second set of items in my questions (Inflation, productivity, etc..) and just want to focus on the first set (Income Statement, balance sheet, cash flow), can I ask how these factors are used to determine a company health? I guess these ones are pretty much consistent even when considered by different analysts? (Or maybe it is a topic for another question..)
    – Eugene S
    Apr 24, 2013 at 9:05
  • @EugeneS Even the first set of factors aren't necessarily consistent between analysts, because a) analysts may have a different understanding of the specific industry, and b) analysts have different preferences, so (for example) some may be willing to tolerate higher levels of debt on a balance sheet than others.
    – John Bensin
    Apr 24, 2013 at 11:13
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    @EugeneS See also en.wikipedia.org/wiki/Value_investing. Notably "Book value is most useful in industries where most assets are tangible. Intangible assets such as patents, software, brands, or goodwill are difficult to quantify". A lot of what's on the balance sheet could be subject to varying valuation techniques.
    – Chris W. Rea
    Apr 24, 2013 at 12:43
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Discounted Cash Flow model to find the intrinsic value

The most common method to estimate the intrisic value of a stock, or of any other cashflow-generating asset, is the discounted cash flow model. To do a DCF valuation you are assuming that every investment is a present value of all future cashflows that the investment will generate. If you own share in a business you can receive dividends or the company can buyback shares (which creates value for the shareholder). Usually, analysts evaluate the Free Cash Flow that the company will generate in the future. Then they find the present value of all future cash flows to find the value of the firm. The DCF is a very flexible model and you can put a lot of different assumptions that can take into account macroeconomics variables (interest rates, inflation, exchange rates, commodity prices) but also company specific metrics (growth, ROIC, ROE, Margins, etc).

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