Fundamental value for a stock is typically defined in terms of its power to generate cash flows. If we discount a company’s cash flows from the future to today at an appropriate discount rate (which should reflect the risk inherent in investing in stocks with similar characteristics to our company) then we can calculate an approximately fair value to pay for the stock today. Comparing that value to the current share price can give us some idea about whether it is over- or under-priced by the market.
However, not all stocks pay cash flows (dividends). For these stocks – often growth stocks – we usually can’t rely on a ‘dividend discount model’ like the one described above. Instead, we could look at its internal return on equity (ROE), its earnings growth rate, its earnings yield (the inverse of its price-to-earnings ratio) and its competitive position amongst its peers for an idea about whether the stock is fairly priced. Since the prices of growth stocks project uncertain streams of future cash flows, it is inherently more difficult to identify a fair price for such stocks by quantitative means. Qualitative analysis is therefore usually helpful.
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