by Bruce Fenton

Long-term value investors understand that buying a stock is not unlike buying a business. In order to arrive at a fair price, the buyer needs to understand the fundamentals of the business. Today, we examine why a stock, like a business, is worth what it can earn in the future.

When finished, you should see why stock prices fluctuate, positively and negatively, with earnings expectations and interest rates. The fundamental analysis of the financial affairs of the business is required to gain a better understanding of the nature and operating characteristics of the company. Value investors believe that the value of a stock is influenced by 1) the underlying financial performance of the company that issued the stock, and, 2) the amount of risk inherent to the owner.

This historical perspective on the company’s performance includes examining its competitive market position, composition and growth of sales, profit margins, dynamics of company earnings, its liquidity position, and finally the company’s capital structure.

Most of this information can be found in the financial records of the business. The balance sheet of the business shows us the book value of what we would own if we bought the business and, also important, what we would owe. The balance sheet is a snapshot in time that shows shareholder equity. Viewed over a number of periods, the balance sheet provides a series of progress reports toward growth of equity.

The income statement and statement of cash flows provide us with information on the liquidity and cash flow. As any owner of a business can attest, “cash is king.” Huge sales and profits are meaningless unless the business generates cash to pay operating expenses.

With this information, plus our opinions of how the economy and the industry structure (competition) will influence future performance, we can estimate future earnings.

The final component in the valuation process is to build in reward for the risk we take as investors. The most basic stock valuation models compare the historical performance of stocks to a risk-free investment such as the 90-Day U.S. Treasury Note over an extended period of time. The average difference represents the risk premium that an investor must receive, over and above risk-free returns, in order to be adequately compensated for the investment. (Note: this is a simplified model. More complex models will include changes in future earnings as well as a future stock-selling price.)

When interest rates have fallen and earnings are up, mathematically this increases the fair value of stock share prices. That is why those who say the market is too high by simply looking at historical price earnings (P/E) and other standards that do not factor in falling interest rates and increasing corporate earnings may be making a mistake!

Bruce Fenton is a financial consultant, a writer, and the Managing Director of Atlantic Financial Inc. Bruce welcomes inquiries, comments, and questions. He can be reached by contacting The Fenton Report.