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Narrator: At its core, fundamental analysis is about estimating the intrinsic value of an investment. There are a lot of ways to estimate this. You might even be familiar with some of these concepts if you've ever bought or sold a home or own a business. In this video, we'll look at three methods for estimating intrinsic value: comparison, build up, and discounted cash flow. First, let's talk about the comparison method.
This involves comparing the asset you're analyzing to similar assets that have a known value. It's an analysis method an appraiser might use to help value your home. First, the appraiser gathers information on comparable homes in your area that have sold recently. This gives the appraiser a baseline for the approximate value of your home.
Then, the appraiser adjusts the price to account for differences between your home and comparable homes. Have an extra bedroom and bathroom? That should likely increase the value a bit. Kitchen smaller than average? That might bring the value down a little. The appraiser makes comparisons like this until she lands on a final estimate.
The comparison method is used for valuing homes because homes are pretty similar. But businesses usually have a lot more moving parts. They may require more of a "build-up" approach.
A build-up approach is done by adding up the value of a business' components. Take this mechanic's shop. An appraiser might start with the value of the land and the building. Then, he accounts for all the equipment and assets the shop owns, like tools, lifts, and tow trucks, to perform its business. Finally, the appraiser builds up, or adds, all these parts together to determine a final estimate of the business' value.
This method works if the appraiser can reliably estimate the value of all of a business' components. But can you imagine trying to do this for a multi-national corporation?
When it comes to investing in stocks, most companies are too big and diverse for investors to estimate their value with the comparison or build-up method alone. Instead, many investors use the more sophisticated discounted cash flow, or DCF, model. While the math is a bit complicated, the concept behind the DCF model is fairly straight forward.
It starts with the idea that a stock's value is equal to a shareholder's portion of all the company's earnings over time.
Animation: Chart shows earnings growth from zero to 11 years. Green bars increase in height from zero to 11.
Narrator: The DCF model assumes that those earnings will grow over time, theoretically making the company and the investor's share in it more valuable.
Animation: Each bar on the earnings growth chart from zero to 11 years decreases as the discount rate is applied.
Narrator: But of course, the investor can't ignore the risk of the company not meeting her expectations, so she discounts that future value accordingly. She's left with an estimated value of her share of the company's earnings. This represents the stock's intrinsic value.
The DCF is a powerful tool that can help you gain confidence to make investment decisions.
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