The Motley Fool, investing guru Benjamin Graham and many other illustrious investors have recommended that individual investors take the time to read into companies' and governments' financials before buying a security. Studying a company's financial statements, structure, management and prospects helps investors form their own ideas about the value of shares or bonds, regardless of market price. This idea is the company's fundamental value and it is different for every investor. Fundamental value changes when a factor important to the investor changes, but the meaning and magnitude of the change also differs from investor to investor.
Fundamentals are the facts of the company. Investors look at financial statements, reports and news releases and more financial statements when assessing a company's fundamentals. Different investors put more or less emphasis on different characteristics, but virtually all consider earnings and earnings growth, debt, cash flow and free cash flow, working capital, dividends and dividend growth.
Investors synthesize financial information and apply a series of measurements to the facts of the company to arrive at what they believe to be the company's fundamental value. Popular measurements include return on capital or return on invested capital, book value and debt to equity ratio. Investors then often arrive at their own valuation of the company, usually expressed as a price per share or bond.
Changes in Stock
Market price per share fluctuates constantly based on changing expectations due to company news and the overall performance of the economy. An individual investor's fundamental value for a company changes much less and she can compare her fundamental value to the market price per share to find good buying or selling opportunities. If something in the fundamentals that she pays particular attention to changes -- earnings, debt, dividend yield -- she can adjust her valuation proportionately.
Changes in Bonds
Fundamental value is not as frequently applied to bond as to stocks, simply because bonds are an IOU instead of ownership in the company. To assess the fundamental value of bonds, the investor assesses the overall solvency of the issuer. The investor's idea of the likelihood that the issuer can pay back the principal paired with expected future interest rates form the basis of the investor's fundamental value for the bond. Similarly, a change in the creditworthiness of the issuer or the prevailing interest rates changes the investor's valuation.
- Benjamin Graham; "The Intelligent Investor"; 2003
- Benjamin Graham; "Security Analysis"; 2004
- Wichita State University; Chapter 5: How to Value Bonds and Stocks; Rodney Boehme
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