How does an investor determine if a stock is undervalued, overvalued, or trading at fair market value? With fundamental analysis, this may be done by applying the concept of intrinsic value. If all the information regarding a corporation's future anticipated growth, sales figures, cost of operations, and industry structure, among other things, are available and examined, then the resulting analysis is said to provide the intrinsic value of the stock.
To a fundamentalist, the market price of a stock tends to move towards its intrinsic value. If the intrinsic value of a stock is above the current market price, the investor would purchase the stock. However, if the investor found through analysis that the intrinsic value if a stock was below the market price for the stock, the investor would sell the stock from their portfolio or take a short position in the stock.
There are several steps associated with fundamental analysis. The investor must make an examination of the current and future overall health of the economy as a whole. Attempt to determine the short-, medium- and long-term direction and level of interest rates. This may done through interest rate forecasting. An understanding of the industry sector involved, including the maturity of the sector and any cyclical effects that the overall economy have on it, is also necessary.
Once these steps have been undertaken, then the individual firm must be analyzed. This analysis must include the factors which give the firm a competitive advantage in its sector (low cost producer, technological superiority, distribution channels, etc.). As well, an in-depth look at the firm must be undertaken. Such factors as management experience and competence, history of performance, accuracy of forecasting revenues and costs, growth potential, etc., must be examined.
All the steps above give a qualitative overview of the firm's position within its sector and the economy as a whole. This is necessary in order to understand whether a quantitative analysis should be undertaken. If numbers must come into play, there are two relatively simple models which can be helpful for the investor willing to better understand the firm being investigated for investment. The two most commonly used methods for determining the intrinsic value of a firm are the dividend discount model, and the price/earnings model. Both methods if employed properly should produce similar intrinsic values.