Basic Methods for Measuring Value Are Important But Often Overlooked
“I never attempt to make money on the stock market,” Warren Buffett once said. “I buy on the assumption that they could close the market the next day and not reopen it for five years.”
Buffett, the richest man in the world, might be considered the poster child for fundamental analysis. He’s on one side of an old debate about the usefulness of relying mostly on company-specific financial data to determine stock values. The other side of the debate insists that fundamentals are already reflected in a stock’s price and that technical analysis, which is studying how a stock performs in the market, is a better way to find winning opportunities.
It is of little consequence that the debate will probably never be settled. Many investors incorporate both fundamental and technical analysis in their decision making. The fact is that the financial markets rely heavily on fundamental analysis in order to set prices and make decisions to buy or sell. It’s a good idea to understand this essential aspect of stock valuation, even if only to gain a better perspective on the universe of stock valuation techniques.
In Good Company
Fundamental analysis is a technique that attempts to establish a stock’s value based on information that is fundamental to the company. This information includes the company’s earnings, dividends, and other variables that a publicly traded company must make public.
Earnings are almost always the dominant factor in a stock’s price. After all, what other reason does a corporation have to exist but to earn money? A company’s ability to earn money says much about what its dividends or capital growth might look like in the future. Earnings are sliced and diced in many ways and form a basis for other valuation measures such as price/earnings ratio and earnings per share.
Dividend activity is important because it says a lot about what the company is doing with its earnings. Dividend yield is the sum of dividends paid per share in one year divided by the stock price. The dividend payout ratio measures the percentage of earnings that are paid as dividends.
Book value represents net worth, or what would be left if the company were to close its doors and use its assets to pay its liabilities. Book value also figures into the price/book ratio, which is the stock price divided by the book value per share. This represents the value of the business over and above the value of its assets.
Fundamental analysis is an important part of stock valuation, but it’s usually just the beginning. Choosing investments that are appropriate for your portfolio typically requires careful research that includes a range of variables, including your time horizon, risk tolerance, and personal circumstances and goals.
The return and principal value of stocks fluctuate with changes in market conditions. Shares, when sold, may be worth more or less than their original cost.
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