July 26th, 2021 | Fundamental Analysis in the Times of Digital Transformation.

The Birth of Fundamental Analysis.

By definition, Fundamental Analysis is the analysis of the company’s condition (or, health) as well as the market potential with respect to the evolution of the market and the activity of its competitors. 

In the classic formulation by Benjamin Graham, the father of value investing, fundamental analysis was based on the in-depth analysis of the company’s assets and the ratio between the recent profits and the overall company’s market valuation.

Until this day, “The Intelligent Investor” by Graham (1949, re-edited until the fourth edition in 1973) remains the bible for all value investors out there. Value investors still look into the company’s books and analyze the overall situation in the market including the political situation, interest rates, employment, the housing situation, or income per capita while making investment decisions.

However, is this formulation optimal when it comes to evaluating businesses in times of Digital Transformation? Especially, online businesses based on software rather than manufacturing and protected Intellectual Property such as patents? Let’s take a closer look.

Borrow From The Future.

But what about new companies operating in the field of new technologies, such as quantum computing, blockchains, or telehealth? Investing in this area is often referred to as “speculative” to the fact that the prices of assets and companies operating in these markets are explosive and don’t follow the same dynamics as the more “traditional” companies based on manufacturing, construction, engineering, trade, or services involving human factor such as consulting or education.

Indeed, the valuation of these new ventures varies a lot which is mainly because they are hard to value. This is because, in times of digital transformation, the fundamental analysis following traditional measures such as the price-to-earnings ratio (also known as P/E) is simply impossible. 

These new businesses are often community-driven, running on the enthusiasm of their developers, and designed to grow for a long time before they will eventually generate any earnings. Or, before the service they provide will get adopted by businesses and individuals.

To be real, in most cases the price-to-earnings ratio of these companies is flat at zero. That’s why the valuation of these businesses is based on the prediction of future potential rather than on the current state of affairs. Since these predictions follow the current sentiment in the market, and the crowd’s group fearful or greedy reactions potentiate the price fluctuations on top of that, the prices jump up and down like crazy. 

But does it mean that the new businesses created in the times of digital transformation have no intrinsic value at all? Of course not. It just means that the approach to the Fundamental Analysis should get adjusted to this new reality.

How To Do Fundamental Analysis in Times of Digital Transformation?

As mentioned before, since the new projects often have no physical assets and no patents (as they are based on software) and their value is conditioned on the future, the rules of the classic fundamental analysis don’t apply. In this situation, the following three factors become the grounds for the fundamental analysis.

1. The Assessment of the Potential of the Whole Market Sector.

The first fundament is the potential of the whole sector. History knows examples of heavily overvalued markets, the most famous being the tulip mania in the Dutch Golden Age. During this frenzy, the bulbs of rare and fashionable tulips could cost as much as a house or even a ship. As it soon turned out when the bubble popped, the value of the whole tulip industry was flat at zero. When the crowd stepped away from tulips as a store of value, their price rapidly dropped toward zero.

Hence, the first question should be: does the whole market have potential? What is the scope of the possible applications? Is this another revolution such as the Internet thirty years ago, or is it yet another bunch of tulips?

2. The Relative Novelty of the Project.

The second aspect is the value of the project compared to other projects in the same space. Is the difference quantitative or qualitative? As Peter Thiel likes to say, successful companies don’t compete; they innovate and become leaders of their own niche. 

Therefore, the question is: what is the added value of the project? What new functionalities does it offer? Are these functionalities easy to copy or reproduce? This sounds trivial but in practice, there are lots of similar projects that go forward head to head despite that clearly, there is only space for one player in the market.

3. People.

The last important aspect is the credentials of the people involved. This one is tricky too! Even the best idea will remain an idea without the proper execution. Yet, people who become authorities in a certain area, often enjoy the aureola effect and proceed to launch new ventures and sign them with their names despite the lack of proper credentials. As a result, projects with a few famous people on board can still fail.