Estimate what a fundamental analyst might consider to be the current intrinsic (realistic) value of the company’s shares

Solution:-The concept of fundamental analysis focuses on valuing a share based on the underlying fundamentals of the business.

A fundamental analyst basically looks at a business and tries to evaluate how the business is going to perform in the future based on a variety of factors related to the company, competition, industry, economy, etc., where the factors are not just financial but includes all possible factors that may directly or indirectly impact the business such as technology, government policies, competitive advantages, management, etc.

After evaluating all the above said factors, the primary methods that are used by analysts in the practical world to calculate the intrinsic value of a stock as follows:

• Discounted Cash Flow Method (DCF): Under the DCF method, the fundamental analyst uses his evaluation of the business (as described above) to forecast the future cash flows expected from the business and discounts those cash flows at the rate of cost of capital. The sum of present values of all the discounted future cash flows so arrived is the valuation of the business.
  • This involves forecasting the future revenues, costs, growth rates, capital expenditures, future equity issues, buybacks, etc
  • For the future years till which the business is expected to grow at abnormal rates, the analyst calculates all the above said data points, thus arriving at free cash flows for individual years
  • A terminal value of business is calculated to account for the cash flows from the period when business growth becomes normal.

• Relative Valuation: There are few forms of relative valuation as follows:
  • In this method, the analyst calculates value of a share based on the valuation of the shares of the company's peers, adjusted for any differences in the risk and growth profiles. For e.g. If on an average, the shares of the peers of a company are trading in the market at 20 times their EPS (known as P/E ratio), than the analyst may calculate the value of share at 25 times its EPS, based on the 20 times multiple of peers, adjusted for difference in risk and growth profile of the company at hand. Again, the evaluation of various factors related to the company's business (as decribed above) comes handy for this exercise.
    • Similar to P/E ratio, there are various multiples that are used under this category by analysts such as
      • EV/EBITDA
      • EV/EBIT
      • PEG
      • EV/Sales
  • The analyst may also use the valuation multiples (same as described above) used in comparable M&A transactions to value a company's share
  • Relative valuation also includes valuing a stock relative to its book value

• Balance Sheet methods: These methods aren't very popular in practical world. These include valuing a share using the values of its assets and liabilities. The various values used are book value, replacement cost, liquidation value, etc.