Fundamental analysis has been a cornerstone of investing since about the time Graham & Dodd’s Security Analysis wasfirst published in 1934. The premise of fundamental analysis is simple and profound: Values reported in and derived from financial statements can explain stock market values.
Fundamental analysis had a long history of success. But the fundamental approach to stock valuation has a recent history of failure. These so-called “failures” that come to mind for recent investors are often stocks such as Netflix, Tesla, GameStop, and others. The failures are most apparent when stock analysts have used financial statements to estimate intrinsic corporate value.
This application of fundamental analysis – value investing or value strategies – is the embodiment of the adage, “buy low, sell high.” (Fundamental analysis is also applicable to growth strategies). We know the adage must be true, and as Lakonishok, Shleifer, and Vishney reported so concisely in their 1994 study, “Value strategies yield higher returns because these strategies exploit the suboptimal behavior of the typical investor….”
If the use of fundamental analysis is the embodiment of the adage, then why hasn’t it worked in recent years? Will fundamental analysis be replaced with something else like so many other 20th century ideas?
That’s the problem when we endure a slump. We don’t know during the slump whether it’s a slump or the beginning of the end. Part of the venerable 20th-century Capital Asset Pricing Model (CAPM) has already been at least partly retired: Factor analysis gives a better explanation for investment return variability than CAPM’s simple appeal to risk. Maybe we’ll retire fundamental analysis too?
To address whether fundamental analysis might have a future, we start by discussing two well-known valuation metrics. These metrics by themselves don’t speak directly to the intrinsic value of a company, but they can enable comparisons of value across time, stocks, or indexes based on fundamental data. Next, we present a detailed fundamental analysis example. It illustrates the calculation of intrinsic value in a way that might offer hope for the reemergence of fundamental analysis.
Valuation ratios and signs of fundamental analysis failures
Valuation ratios provide a quick glimpse of a stock’s value. Investors can use them to make comparisons of the stock of similar companies, though comparisons across industries can give invalid results. For example, a comparison of two big oil companies would be a suitable use of the ratios, but a comparison of a bank stock and an online merchandiser might not be fair.
Investors can also use valuation ratios to make judgments about whether a stock’s market price seems high or low compared to the company’s historical ratios or the current market average for the ratios. It isn’t enough to say Apple’s (AAPL) recent $133 price is higher than it was last year and higher than most stocks. Past prices and absolute prices (like $133) are an unsuitable basis for judging whether prices are high or low. The price needs to be anchored – expressed as a ratio – to make that call. The anchor must be a value that logically bears on stock prices.
The goal of fundamental analysis is to value a company – to put a price on the corporation and compare the result with the market price. The most widely reported fundamental valuation metric of the market price is the Price/Earnings ratio (P/E), which is the price per share divided by earnings per share. It’s reported on many stock quote websites.
The 2018 average P/E for the S&P 500 Index using Robert J. Schiller’s “cyclically adjusted” P/E ratio equaled about 36; it’s about the same as of this writing. That is, for every dollar of earnings, the average S&P 500 stock sold for about $36 per share. This is a high P/E compared to the ten-year period ending in 2018 when the average cyclically adjusted P/E equaled about 26. Compared to P/Es for the past 150 years according to Schiller, 36 is extremely high. It was higher only twice. The first time was in 1929 near the onset of the great depression and the second time was in 2000 when the “dot-com bubble” burst.
With such high P/E ratios of late, you have to wonder whether they are a fair measure of value. Tesla (TSLA) illustrates how stock prices can become divorced from fundamentals. TSLA’s recent price was $710.87 and its annual diluted earnings per share equaled $0.64. That’s a P/E ratio of 1,110.73. In other words, if you bought TSLA at this recent price, you paid $1,110.73 for each dollar it earned.
TSLA’s stock price is so detached from its earnings, any fundamental analysis based on earnings can look frivolous. For example, we could estimate future earnings for the next five years with the assumption the stock price rises 10% per year and the P/E ratio falls to 36 – the recent S&P 500 Index average, a more believable, albeit high P/E – by the end of the fifth year:
The five-year compounded annual earnings growth rate in this projection equals 118%. That is, earnings more than double each year on average. (You can decide whether you think that’s attainable). But Tesla didn’t report its first positive annual net income until its 2020 annual report, and for the last three years, the annual earnings growth rate has been 66%. (You can decide whether you think that’s sustainable). Even this historical three-year growth rate is impressive, but in 2020 the company issued $20 billion in new shares after increasing the outstanding shares by an annual average of 9% since 2012. If Tesla continues to raise capital by diluting its stock, the P/E will probably remain high unless the stock takes a big tumble.
Despite stock dilution along with the extremely high P/E ratio and the earnings growth it implies, the markets have rewarded Tesla shareholders. The compounded average annual growth rate in the stock price since its 2010 initial public offering is 53%!
Book value is the value of the equity portion of the balance sheet. It’s assets minus liabilities. Book value is divided by the number of outstanding shares to arrive at the per-share P/B. The significance of book value lies in a corporation’s theoretical liquidation value. It’s a conservative valuation measure because asset values are expressed at cost, not their current value. Depending on the corporation’s asset mix, asset value is often greater than booked value. Therefore, the subtraction of liabilities from a cost-based asset value would lead to an understatement of the true difference between assets and liabilities, the true value of equity.
According to Siblis Research, price-to-book (P/B) value per share since 2017 has typically ranged below $10; the average was about $4. That is, for every dollar of booked equity, the average stock sold for about $4 per share. Stock prices were four times the value of equity per share. But Netflix (NFLX) is another example of extremes. In the communications sector, the sector in which NFLX competes, the average P/B ratio has been closer to $3.60, according to Siblis Research. Yet NFLX’s P/B ratio per share was $22.20 at the end of 2020, six times the sector average. (You can decide whether you think that’s sustainable).
Is Fundamental Analysis Dead?
It’s useful to point out that fundamental analysis is more art than science; judgment plays an important role. Therefore, the details of the methods vary somewhat from source to source; what you see here are not the only ways to value a stock because details can vary in the methods.
At least by the metrics in the examples – P/E and P/B – it’s tough to make the case that corporate financial results explain stock prices. Part of the reason fundamentals fail us lies in the more widespread use of potentially deceptive – albeit legal – accounting transactions and practices. For example, the growing use of stock buybacks spuriously increases earnings per share because it reduces the share count without reducing earnings – it’s a balance-sheet-only transaction. Similarly, share buybacks also spuriously increase return on equity (ROE) and return on assets (ROA) ratios because they reduce equity and assets without reducing net income. The effects of buybacks can be deceptive because the resulting higher ratios give the impression of greater profitability.
Another factor that contributes to a detachment of fundamental and market values lies in understated book values caused by expensing investments – posting transactions to the income statement instead of treating them as assets – in intangible assets like research & development and information technologies. Expensing investments in intangibles understates net income, thereby increasing the P/E ratio. Also, because the investments fail to appear as an asset, the practice understates assets and therefore understates book value (equity). According to Lev and Srivastava (2019), corporations started to increase investments in intangibles as a percentage of all investments in the late 1980s. Investments in intangibles had almost doubled the intangible investment rate recently; intangible investments in the U.S. exceeded $2 trillion in 2017.
The missing variable, the factor fundamentals omit is speculation about expected growth in earnings, growth in book value, and other valuation inputs like sales. The historical values used in preparing financial statements couldn’t possibly reflect growth by themselves. Fundamental analysis can’t possibly explain stock prices if the historical values are minuscule compared to future values. This problem presents itself when the market projects super growth, the kind of growth we have gotten a glimpse of in companies like Tesla and Netflix.
To address the inadequacies of fundamental analysis caused by accounting nuances, many analysts use cash flow to value businesses instead. Cash flow is simpler. You don’t need to adjust cash balances with judgments about ethereal or exogenous influences like depreciation and taxes. It is what it is. The only judgment-based adjustments required in the valuation process – and these adjustments would also be made with traditional valuation inputs – are growth rates and the discount applied to future cash flows.
Price-to-Free Cash Flow
Many analysts reject the traditional P/E, P/B, and other income statement- and balance sheet-derived valuation metrics because accounting practices on which the metrics are based can introduce bias in the ratio inputs. That’s not to say the bias diminishes their accounting value; rather, though they serve the accounting purpose, they don’t always serve the valuation purpose of fundamental analysis. For example, net income often includes non-cash items like depreciation using sometimes arbitrary tax-driven methods. Also, a contra account like “allowance for doubtful accounts” is a credit to the accounts receivable balance; it reduces total assets, but management makes a judgment about the size of unrecoverable revenues.
Free cash flow has gained traction in stock valuation. Free cash flow is cash flow from operations – cash produced exclusively from the business and not including cash from financing and investing – minus purchases of property and equipment. The idea is that free cash flow is discretionary cash, cash available to management for applications to the business or for shareholders. Free cash flow – instead of earnings, book value, or other accounting values – can serve as the basis for estimating the corporation’s intrinsic value.
One method for finding free cash flow for the firm for a certain period requires two inputs from the cash flow statement:
Free Cash Flow = Net Cash from Operating Activities – Net Capital Expenditures
To place a value on the business, the method takes the discounted present value of projections of free cash flow. Whereas the equation above gives the free cash flow for one period, projections of multiple period cash flows are needed to arrive at a valuation. This discounting practice is the standard method used in finance to value any asset, and it can also be applied to other valuation metrics like P/E.
The discounting idea rests on the premise that money received (paid) today is worth more than money received (paid) in the future. Risk, interest rates, and inflation are the main factors that lead to a discount rate, a discount percentage. To find intrinsic value, the most defensible discount rate might be the corporation’s weighted average cost of capital (WACC). A corporation that borrows money offers the simplest example of WACC: The WACC roughly equals the corporation’s cost of borrowing, its weighted average interest rate.
To illustrate only the method for calculating free cash flow and valuation we use Amazon.com’s (AMZN) recent cash flow statements. (Please see this important qualifier about the following illustration ). Data like these are also summarized by other reputable online sources like Morningstar and Yahoo Finance:
Values except per-share values are expressed in millions of U.S. dollars.
Next, the method projects free cash flow using the previous five years of free cash flow growth . The following table provides the inputs:
We calculate an arithmetic average annual growth rate roughly equal to 41% and a mean free cash flow of $19,031 million per year. We could use this recent mean cash flow and historical growth rate as the basis for calculating projected free cash flow. However, 41% per year is quite high. Furthermore, the high volatility in historical growth rates (ranging from -20.49% to +131.61%) suggests we should have less confidence in an average as a representative value of historical growth. Therefore, judgment, in this case, could lead to accepting the $19,031 million annual cash flow starting point but cutting the projected growth rate to 25%, an arbitrary but perhaps more likely growth rate.
Before you look further at this example, a little reminder can help: The process values cash flows the corporation generates, not cash flows to investors. We could value cash flows to investors if we wanted to calculate the value of the stock. But we’re not trying to value the stock; the purpose is to find the intrinsic value of the corporation. If we arrive at a defensible number, we can reduce the intrinsic value to a per-share number and compare it with the per-share market value of the stock to decide whether the stock market over- or under-values the stock.
Based on Amazon’s 2020 annual report, we estimate its WACC at 3.0%  and assume it will persist perpetually. This 3.0% is the discount rate. Projections look like this:
This sum of discounted cash flows is the estimated present value (year-end 2020) of the firm in millions of dollars based only on five years of projected cash flows. At the end of 2020, 503 million shares were outstanding. Therefore, on a per-share basis the firm’s value so far equals $350.94. But we’re not done. We haven’t yet considered the biggest contributor to intrinsic value, a terminal value for the company.
Here’s why we need a terminal value: A company’s value is the discounted present value of its future cash flows. We must assume the cash flows will continue forever unless we know something about an end to the corporation. However, so far, the method only discounts five years of cash flows. Even if we plan to sell the stock after five years, the perpetual cash flows after five years still need to be included because they would be the basis for the stock price in five years when we sell it.
Those perpetual cash flows after year five can be discounted with a simple formula: Periodic cash flow (annual cash flow, in this case) divided by the discount rate. We could just use the year-five cash projected flow from the table above – not its discounted value, its nominal value, $58,079 million, and divide by the WACC, 3.0%: 58,079/ 0.03 = $1,935,954 million. Next, we discount that year-five value to the year-zero value using the present value formula, future value divided by 1 plus the discount rate with the denominator raised to the power of the number of periods, five years: 1,935,954 / (1 + 0.03)5 = 1,669,971. This is the present value of the terminal value in millions of dollars. We add that to the sum of the present value of the first five years of cash flows: 176,522 + 1,669,971 = 1,846,943.
One last adjustment: We must deduct the corporation’s debt so we’re left with the intrinsic value free from encumbrances. In 2020, Amazon’s debt equaled about $210,774 million. The final corporate intrinsic value equals $1,635,719 million.
Finally, we can reduce the present value of cash flows to a per-share value by dividing it by the 503 million outstanding shares: 1,635,719 / 503 = $3,252. This outcome says Amazon’s intrinsic value was $3,252 per share. Because all values are based on 2020 year-end cash flows and shares, we compare this outcome with the stock’s closing market value on December 31st, 2020, $3,256.93.
Here are three defensible conclusions:
- Amazon’s intrinsic value is the same as its market value, therefore the stock is fairly priced.
- Understated growth leads to understated intrinsic value: The method used to find Amazon’s intrinsic value used an excessively conservative five-year growth rate and the calculation of the terminal value failed to assume any free cash flow growth, further compounding the conservative bias. Subject to a revised analysis, Amazon’s intrinsic value exceeds its market value which presents a buying opportunity in the stock because we would expect the market value to rise to the intrinsic value.
- Understated WACC leads to overstated intrinsic value. With interest rates currently at historic lows, we should expect WACC values to increase in the future. A larger WACC in the denominator of the present value equation would produce a smaller present value. If the intrinsic value is smaller, the market price overstates the value and we would expect the market price to fall to the intrinsic value.
Income statement and balance sheet values fail to explain stock prices, or at least their validity as explanatory variables has diminished because of changes in business and accounting practices. Fundamental analysis using those inputs might be dead. As an alternative, free cash flow might offer hope that fundamental analysis is not dead. Cash flow is less vulnerable to distortion than values like earnings and book value. Combined with the user’s judgment, free cash flow can offer a valuable explanation for stock prices.
 Earnings is the same as net income.
 This illustration is only the calculations performed on free cash flow. It is not a full “Graham & Dodd” fundamental analysis which would include analyses of the global economy, regional economies, the industry, and many other factors.
 Using historical values only usually leads to poor projections. More thoughtful projections incorporate other information about the corporation’s growth prospects.
 This WACC estimate is based only on the corporation’s issues of “notes” and each issue’s average interest rate. A complete WACC calculation would also include all forms of debt, and the interest expense would be after-tax. Also, the company assumes a cost associated with its stock. It does not pay a dividend, so the cost of equity would be small. But a complete WACC calculation would include this, too.
 The formula for the discounted present value is PV = FV / (1 + i)n where PV = present value, FV = future value, the projected value, i = the WACC, the discount rate, and n = the number of periods.
 Rounding errors explain why the column values don’t exactly sum to the reported sum. You’ll see this error elsewhere, too.