Fundamental analysis
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Fundamental analysis of a business involves analyzing its financial statements and
health, its management and competitive advantages, and its competitors and markets.
When applied to futures and forex, it focuses on the overall state of the economy, interest
rates, production, earnings, and management. When analyzing a stock, futures contract,
or currency using fundamental analysis there are two basic approaches one can use;
bottom up analysis and top down analysis.[1] The term is used to distinguish such analysis
from other types of investment analysis, such as quantitative analysis and technical
analysis.
Fundamental analysis is performed on historical and present data, but with the goal of
making financial forecasts. There are several possible objectives:
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to conduct a company stock valuation and predict its probable price evolution,
to make a projection on its business performance,
to evaluate its management and make internal business decisions,
to calculate its credit risk.
Contents
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1 Two analytical models
2 Use by different portfolio styles
3 Top-down and Bottom-up
4 Procedures
5 Criticisms
6 References
7 See also
8 External links
[edit] Two analytical models
When the objective of the analysis is to determine what stock to buy and at what price,
there are two basic methodologies
1. Fundamental analysis maintains that markets may misprice a security in the short
run but that the "correct" price will eventually be reached. Profits can be made by
trading the mispriced security and then waiting for the market to recognize its
"mistake" and reprice the security.
2. Technical analysis maintains that all information is reflected already in the stock
price. Trends 'are your friend' and sentiment changes predate and predict trend
changes. Investors' emotional responses to price movements lead to recognizable
price chart patterns. Technical analysis does not care what the 'value' of a stock is.
Their price predictions are only extrapolations from historical price patterns.
Investors can use any or all of these different but somewhat complementary methods for
stock picking. For example many fundamental investors use technicals for deciding entry
and exit points. Many technical investors use fundamentals to limit their universe of
possible stock to 'good' companies.
The choice of stock analysis is determined by the investor's belief in the different
paradigms for "how the stock market works". See the discussions at efficient-market
hypothesis, random walk hypothesis, Capital Asset Pricing Model, Fed model Theory of
Equity Valuation, Market-based valuation, and Behavioral finance.
Fundamental analysis includes: 1.Economic analysis 2.Industry analysis 3.Company
analysis
On the basis of this three analysis the intrinsic value of the shares are determined. This is
considered as the true value of the share. If the intrinsic value is higher than the market
price it is recommended to buy the share . If it is equal to market price hold the share and
if it is less than the market price sell the shares.
[edit] Use by different portfolio styles
Investors may use fundamental analysis within different portfolio management styles.
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Buy and hold investors believe that latching onto good businesses allows the
investor's asset to grow with the business. Fundamental analysis lets them find
'good' companies, so they lower their risk and probability of wipe-out.
Managers may use fundamental analysis to correctly value 'good' and 'bad'
companies. Even 'bad' companies' stock goes up and down, creating opportunities
for profits.
Managers may also consider the economic cycle in determining whether
conditions are 'right' to buy fundamentally suitable companies.
Contrarian investors distinguish "in the short run, the market is a voting
machine, not a weighing machine"[2]. Fundamental analysis allows you to make
your own decision on value, and ignore the market.
Value investors restrict their attention to under-valued companies, believing that
'it's hard to fall out of a ditch'. The value comes from fundamental analysis.
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Managers may use fundamental analysis to determine future growth rates for
buying high priced growth stocks.
Managers may also include fundamental factors along with technical factors into
computer models (quantitative analysis).
[edit] Top-down and Bottom-up
Investors can use either a top-down or bottom-up approach.
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The top-down investor starts his analysis with global economics, including both
international and national economic indicators, such as GDP growth rates,
inflation, interest rates, exchange rates, productivity, and energy prices. He
narrows his search down to regional/industry analysis of total sales, price levels,
the effects of competing products, foreign competition, and entry or exit from the
industry. Only then he narrows his search to the best business in that area.
The bottom-up investor starts with specific businesses, regardless of their
industry/region.
[edit] Procedures
The analysis of a business' health starts with financial statement analysis that includes
ratios. It looks at dividends paid, operating cash flow, new equity issues and capital
financing. The earnings estimates and growth rate projections published widely by
Thomson Reuters and others can be considered either 'fundamental' (they are facts) or
'technical' (they are investor sentiment) based on your perception of their validity.
The determined growth rates (of income and cash) and risk levels (to determine the
discount rate) are used in various valuation models. The foremost is the discounted cash
flow model, which calculates the present value of the future
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dividends received by the investor, along with the eventual sale price. (Gordon
model)
earnings of the company, or
cash flows of the company.
The amount of debt is also a major consideration in determining a company's health. It
can be quickly assessed using the debt to equity ratio and the current ratio (current
assets/current liabilities).
The simple model commonly used is the Price/Earnings ratio. Implicit in this model of a
perpetual annuity (Time value of money) is that the 'flip' of the P/E is the discount rate
appropriate to the risk of the business. The multiple accepted is adjusted for expected
growth (that is not built into the model).
Growth estimates are incorporated into the PEG ratio but the math does not hold up to
analysis.[neutrality is disputed] Its validity depends on the length of time you think the growth
will continue.
Computer modelling of stock prices has now replaced much of the subjective
interpretation of fundamental data (along with technical data) in the industry. Since about
year 2000, with the power of computers to crunch vast quantities of data, a new career
has been invented. At some funds (called Quant Funds) the manager's decisions have
been replaced by proprietary mathematical models.[3]
[edit] Criticisms
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Economists such as Burton Malkiel suggest that neither fundamental analysis nor
technical analysis is useful in outperforming the markets[4]
[edit] References
1. ^ "An Introduction to Fundamental Analysis and the US Economy".
InformedTrades.com. 2008-02-14. http://www.informedtrades.com/13036-introductionfundamental-analysis-us-economy.html#post13168. Retrieved 2009-07-27.
2. ^ Graham, Benjamin; Dodd, David (December 10, 2004). Security Analysis. McGrawHill. ISBN 978-0071448208.
3. ^ "Quant Fund". Investopedia. http://www.investopedia.com/terms/p/pip.asp.
4. ^ "Financial Concepts: Random Walk Theory". Investopedia.
http://www.investopedia.com/university/concepts/concepts5.asp.
[edit] See also
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Lists of valuation topics
Stock picking
Security Analysis
Stock selection criteria
John Burr Williams: Theory
Mosaic theory
[edit] External links
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MIT Open Course Ware
Fundamental Analysis for Currencies
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v•d•e
Stock market
Types of stocks
Stock · Common stock · Preferred stock ·
Outstanding stock · Treasury stock · Authorised
stock · Restricted stock · Concentrated stock ·
Golden share
Participants
Exchanges
Investor · Stock trader/investor · Market maker ·
Floor trader · Floor broker · Broker-dealer
Stock exchange · List of stock exchanges · Overthe-counter · Electronic Communication Network
Stock valuation
Gordon model · Dividend yield · Earnings per
share · Book value · Earnings yield · Beta ·
Alpha · CAPM · Arbitrage pricing theory · TModel
Financial ratios
P/CF ratio · P/E · PEG · Price/sales ratio · P/B
ratio · D/E ratio · Dividend payout ratio · Dividend
cover · SGR · ROIC · ROCE · ROE · ROA ·
EV/EBITDA · RSI · Sharpe ratio · Treynor ratio ·
Cap rate
Trading theories and strategies
Efficient-market hypothesis · Fundamental
analysis · Technical analysis · Modern portfolio
theory · Post-modern portfolio theory · Mosaic
theory · Pairs trade
Dividend · Stock split · Reverse stock split ·
Growth stock · Speculation · Trade · IPO · Market
Related terms trend · Short Selling · Momentum · Day trading ·
DuPont Model · Dark liquidity · Market depth ·
Margin · Rally · Volatility
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