KEY POINTS

• Fundamentals and valuation metrics are used in traditional and value-based approaches to equity securities analysis.
• In the traditional realm, growth rates, margins, return on equity, multiples, and the fundamental stock return are at the heart of this well-known approach to company analysis.
• The extended Dupont formula goes a long way in showing how the multiplicative combination of operating margins, asset turns, interest burden, tax burden and the equity multiplier (leverage) at the company level can impact—either positively or negatively—the shareholders' return on equity.
• Valuation measures such as price-to-sales, price-to-earnings, and price-to-book ratios can be used by investors and analysts to assess whether a company's internal growth opportunities are correctly priced in the marketplace.
• If the fundamental stock return (which includes the sustainable growth rate as measured by times return on equity) falls short of the required return—equivalently if the fundamental stock return lies below the securities market line—then the stock appears to be overvalued. Consequently, the investor should consider selling or short selling the presumably mispriced shares. In theory, the firm's common stock is priced “just right” when the fundamental stock return equals the investor's required return. In turn, a potential buy opportunity is present when the FSR exceeds the required rate. We also examined the traditional (and value-based) role of corporate debt policy.
• Investors and analysts must determine whether a seemingly favorable change in return on equity is due to changes in a firm's real growth opportunities, or whether it is due to an illusionary benefit to shareholders resulting from a debt ratio that exceeds the presumed target or optimal level.
• A value-based metric becomes a VBM when there is a direct recognition of and a formal link to the opportunity cost of capital (via WACC in the EVA formulation) or the investor's required rate of return (via r in the residual income or abnormal earnings model).
• In the VBM approach to company and securities analysis, a firm is not truly profitable unless its return on capital is higher than the cost of capital, including the direct cost of debt and the indirect cost of equity financing. Moreover, the VBM approach emphasizes the concept of wealth creators and wealth destroyers. In this approach, the investor or analyst focuses on the fundamental ability of a firm to create shareholder value.
• EVA momentum is crucial in determining whether or not a company is pointing in the direction of wealth creation or wealth destruction.
• On balance, VBM and traditional metrics can (and should) be combined in a way that provides investors and analysts with a diversity of equity analysis tools to identify potential buy and sell opportunities in the marketplace.