Choosing A Stock Part 2: Fundamental Valuation

This article originally appeared on DriveWealth.

Welcome to Part 2 of the “Choosing A Stock” mini-series. If you missed Part 1, I encourage you to go back, check it out, and give it a read. In Part 2, we will be exploring another strategy that prospective investors might use in order to differentiate between stocks and ultimately come to a conclusion as to which ones are the best option for their portfolios. As mentioned in Part 1, there are many different strategies that investors use to make the most informed decisions possible, but there is no one strategy that is fool proof. This week, we will focus on a technique that is fairly simple, yet very popular: fundamental valuation.

Completing a fundamental valuation takes some time and patience, but it is pretty straight-forward. The main objective of a fundamental valuation is to analyze a company and determine its stock’s intrinsic value. This means that you are trying to determine what you believe the stock is actually worth, as opposed to the current value it holds in the marketplace. Simply put, if the intrinsic value is greater than the price the stock is currently trading at, then the stock might be a good buy. Transversely, if the intrinsic value is lower than the stock’s current market price, then it might be a better idea to sell (or refrain from buying).

Despite the fact that there are multiple ways to determine a stock’s intrinsic value, the foundations of the strategies are the same. A company’s value is the sum of its discounted cash flows. In layman's terms, a company’s worth is determined by all of its future profits added together. However, these future profits must first be discounted to account for the time value of money. For those who are not familiar with the time value of money, it is the notion that a dollar received today is worth more than a dollar received at some point in the future. Moreover, the further into the future, the less that dollar is currently worth.

If you take into consideration the way businesses create value for their owners, intrinsic value is relatively basic and logical. For instance, to explain in the simplest of terms, if you have a small business such as a lemonade stand, its value is the money that can be taken from the company at each year’s end. Further, the only money you can take out of the lemonade stand is what is left over after the expenses incurred to keep the business running. For example, the lemonade stand in question could accumulate expenses such as ingredients (lemons, water, sugar), equipment (table, chair, sign), and salaries of the employees. At the end of the day, even the simplest businesses, like the lemonade stand, are dependent on making a profit (revenue minus expenses); the premise of intrinsic value.

Although using fundamental valuation is slightly more quantitative and, therefore, more intimidating to some people than using only the strategies outlined in Part 1 of this mini-series, I hope that you can now see that it is not intimidating. In fact, if you take your time and think logically, you should be able to add it to your arsenal of tools that help you pick stocks much more effectively – start by determining the intrinsic value. Thank you for reading Part 2 of the “Choosing A Stock” mini-series, stay tuned for Part 3!