What You’ll Learn
There’s two parts to this post, but it’s aims to provide a good basic framework for analysis and valuation.
I keep coming back to a great book that I finished in just a few days.
The book is the fifth edition of Stephen Penman’s Financial Statement Analysis and Security Valuation and Accounting for Value
I highly recommend these books to anyone who wants to learn more about financial statement analysis and security analysis.
In the first chapter Penman shares a few tenets, or “guiding principles,” that he keeps coming back to throughout the whole book.
These guiding principles are not ground breaking. In fact, I’d be more surprised if you haven’t come across these. But these are still the foundational principles, and as with all sound principles they are worth remembering – and sharing.
Keep them close in mind when venturing out into the market space.
Here is some of the wisdom that I’ve paraphrased based on my practice of fundamental analysis over the years.
I do want to make a short mention for #10 and #11 in particular.
As a simple example where a P/E ratio indicates the market’s expectation of future earnings growth, a P/E of 131 for Blackberry (BBRY) is high by any standard.
The fundamentalist questions whether the market is forecasting too much earnings growth. Specifically, point 10 warns you about getting too excited—too speculative—about future growth.
Fundamentalists see speculation about growth as one of the prime reasons for the overpricing of stocks and the emergence of price bubbles.
A valuation method needs to build in protection against paying too much for growth.
A sound valuation method challenges the market’s speculation about growth. A reason why reverse valuation methods like a reverse DCF is highly useful to determine the level of speculation and expectation built into a stock.
Price is what you pay and value is what you get.
So Point 11 warns against referring to the market price when you are calculating value.
If you do so, you are clearly being circular and have ruined the ability of your analysis to challenge prices. Yet analysts allow prices to enter in subtle ways. An analyst who increases her earnings forecast because stock prices have increased—and then applies a valuation multiple to those earnings—commits that error.
It is so easy to do when there is excitement about a stock, for there is a temptation to justify the price.
But the analyst may be joining a chain letter.
Reminds me of a quick example when the iPad first launched and AAPL shares were trading at $380 pre-split, an analyst forecast earnings per share of $28.82 for fiscal year 2011.
Considerably higher than other analysts.
Fair enough – if you can justify the number.
But the analyst also published a price target of $548 per share and, accordingly, issued a buy recommendation. To get this price, the analyst multiplied his 2011 earnings estimate by Apple’s average P/E over the last three years of 19.
See the problem?
The analyst is pricing earnings on the basis of the market’s pricing of earnings, but if that pricing is incorrect it’s already building mispricing into the calculation.
Price was used to challenge the market price, rather than to use the intrinsic value to compare against the stock price.
What you don’t think about is how this particular analyst also compounded the speculation with a forecast. Put another way, if a P/E of 19 represents a mispricing, he contributed to the perpetuation of the mispricing.
No wonder bubbles form. The fundamentalist takes care to apply methods that establish the intrinsic P/E ratio without reference to market prices.
“If you read Graham’s The Intelligent Investor— and one is advised to do so— there is not much in the way of techniques or calculations. Rather, Graham instructs us how to think about investing. He writes as a sage, he offers wisdom. Investing, he says, is first about attitude and approach rather than technique.”
―Stephen Penman, Accounting for Value
In the book the author provides several practical principles to follow for accounting and valuation. It’s a technical and very practical book so if you are unsure of what I’m outlining below, definitely grab a copy to improve your fundamental analysis skills.
Created by Tan KW | Oct 23, 2018
Created by Tan KW | Jun 14, 2018
Created by Tan KW | Apr 20, 2018