Fundamental analysis
Encyclopedia
Fundamental analysis of a business involves analyzing its financial statements
Financial statements
A financial statement is a formal record of the financial activities of a business, person, or other entity. In British English—including United Kingdom company law—a financial statement is often referred to as an account, although the term financial statement is also used, particularly by...

 and health, its management and competitive advantages, and its competitors and markets. When applied to futures
Futures contract
In finance, a futures contract is a standardized contract between two parties to exchange a specified asset of standardized quantity and quality for a price agreed today with delivery occurring at a specified future date, the delivery date. The contracts are traded on a futures exchange...

 and forex
Foreign exchange market
The foreign exchange market is a global, worldwide decentralized financial market for trading currencies. Financial centers around the world function as anchors of trading between a wide range of different types of buyers and sellers around the clock, with the exception of weekends...

, 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. The term is used to distinguish such analysis from other types of investment analysis, such as quantitative analysis and technical analysis
Technical analysis
In finance, technical analysis is security analysis discipline for forecasting the direction of prices through the study of past market data, primarily price and volume. Behavioral economics and quantitative analysis incorporate technical analysis, which being an aspect of active management stands...

.

Fundamental analysis is performed on historical and present data, but with the goal of making financial forecasts. There are several possible objectives:
  • to conduct a company stock valuation
    Stock valuation
    In financial markets, stock valuation is the method of calculating theoretical values of companies and their stocks. The main use of these methods is to predict future market prices, or more generally potential market prices, and thus to profit from price movement – stocks that are judged...

     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
    Credit risk
    Credit risk is an investor's risk of loss arising from a borrower who does not make payments as promised. Such an event is called a default. Other terms for credit risk are default risk and counterparty risk....

    .

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
    Profit (accounting)
    In accounting, profit can be considered to be the difference between the purchase price and the costs of bringing to market whatever it is that is accounted as an enterprise in terms of the component costs of delivered goods and/or services and any operating or other expenses.-Definition:There are...

     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
    Technical analysis
    In finance, technical analysis is security analysis discipline for forecasting the direction of prices through the study of past market data, primarily price and volume. Behavioral economics and quantitative analysis incorporate technical analysis, which being an aspect of active management stands...

     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
Random walk hypothesis
The random walk hypothesis is a financial theory stating that stock market prices evolve according to a random walk and thus the prices of the stock market cannot be predicted. It is consistent with the efficient-market hypothesis....

, capital asset pricing model
Capital asset pricing model
In finance, the capital asset pricing model is used to determine a theoretically appropriate required rate of return of an asset, if that asset is to be added to an already well-diversified portfolio, given that asset's non-diversifiable risk...

, Fed model
Fed model
The "Fed model" is a theory of equity valuation that has found broad application in the investment community. The model compares the stock market’s earnings yield to the yield on long-term government bonds...

 Theory of Equity Valuation, Market-based valuation
Market-based valuation
Market-based valuation is a form of stock valuation that refers to market indicators, also called "extrinsic" criteria .- Examples of market valuation methods :...

, and Behavioral finance
Behavioral finance
Behavioral economics and its related area of study, behavioral finance, use social, cognitive and emotional factors in understanding the economic decisions of individuals and institutions performing economic functions, including consumers, borrowers and investors, and their effects on market...

.

Fundamental analysis includes:
  1. Economic analysis
  2. Industry analysis
  3. Company analysis


On the basis of these three analyses 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.

Use by different portfolio styles

Investors may use fundamental analysis within different portfolio
Portfolio (finance)
Portfolio is a financial term denoting a collection of investments held by an investment company, hedge fund, financial institution or individual.-Definition:The term portfolio refers to any collection of financial assets such as stocks, bonds and cash...

 management
Investment management
Investment management is the professional management of various securities and assets in order to meet specified investment goals for the benefit of the investors...

 styles
Investor profile
An investor profile or style defines an individual's preferences in investment decisions, for example:* Short term trading or long term holding * Risk averse or risk tolerant / seeker...

.
  • Buy and hold
    Buy and hold
    Buy and hold is a long-term investment strategy based on the view that in the long run financial markets give a good rate of return despite periods of volatility or decline. This viewpoint also holds that short-term market timing, i.e...

    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. Eventually '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
    Contrarian
    In finance, a contrarian is one who attempts to profit by investing in a manner that differs from the conventional wisdom, when the consensus opinion appears to be wrong....

     investors
    distinguish "in the short run, the market is a voting machine, not a weighing machine". Fundamental analysis allows you to make your own decision on value, and ignore the market.
  • Value investors
    Value investing
    Value investing is an investment paradigm that derives from the ideas on investment and speculation that Ben Graham and David Dodd began teaching at Columbia Business School in 1928 and subsequently developed in their 1934 text Security Analysis...

    restrict their attention to under-valued companies, believing that 'it's hard to fall out of a ditch'. The value comes from fundamental analysis.
  • Managers may use fundamental analysis to determine future growth rates for buying high priced growth stock
    Growth stock
    In finance, a growth stock is a stockof a company that generates substantial and sustainable positive cash flow and whose revenues and earnings are expected to increase at a faster rate than the average company within the same industry...

    s.
  • Managers may also include fundamental factors along with technical factors into computer models (quantitative analysis
    Quantitative analysis
    Quantitative analysis may refer to:* Quantitative analysis , an analysis technique applying mathematics stochastic calculus to finance...

    ).

Top-down and bottom-up

Investors can use either a top-down or bottom-up approach.
  • The top-down investor starts his analysis with global economics, including both international and national economic indicator
    Economic indicator
    An economic indicator is a statistic about the economy. Economic indicators allow analysis of economic performance and predictions of future performance. One application of economic indicators is the study of business cycles....

    s, such as GDP growth rates, inflation
    Inflation
    In economics, inflation is a rise in the general level of prices of goods and services in an economy over a period of time.When the general price level rises, each unit of currency buys fewer goods and services. Consequently, inflation also reflects an erosion in the purchasing power of money – a...

    , interest
    Interest
    Interest is a fee paid by a borrower of assets to the owner as a form of compensation for the use of the assets. It is most commonly the price paid for the use of borrowed money, or money earned by deposited funds....

     rates, exchange rate
    Exchange rate
    In finance, an exchange rate between two currencies is the rate at which one currency will be exchanged for another. It is also regarded as the value of one country’s currency in terms of another currency...

    s, 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.

Procedures

The analysis of a business' health starts with financial statement analysis that includes ratios
Financial ratio
A financial ratio is a relative magnitude of two selected numerical values taken from an enterprise's financial statements. Often used in accounting, there are many standard ratios used to try to evaluate the overall financial condition of a corporation or other organization...

. 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
Thomson Reuters
Thomson Reuters Corporation is a provider of information for the world's businesses and professionals and is created by the Thomson Corporation's purchase of Reuters Group on 17 April 2008. Thomson Reuters is headquartered at 3 Times Square, New York City, USA...

 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
Discount rate
The discount rate can mean*an interest rate a central bank charges depository institutions that borrow reserves from it, for example for the use of the Federal Reserve's discount window....

) are used in various valuation models. The foremost is the discounted cash flow
Discounted cash flow
In finance, discounted cash flow analysis is a method of valuing a project, company, or asset using the concepts of the time value of money...

 model, which calculates the present value of the future
  • dividend
    Dividend
    Dividends are payments made by a corporation to its shareholder members. It is the portion of corporate profits paid out to stockholders. When a corporation earns a profit or surplus, that money can be put to two uses: it can either be re-invested in the business , or it can be distributed to...

    s received by the investor, along with the eventual sale price. (Gordon model
    Gordon model
    The Gordon growth model is a variant of the discounted cash flow model, a method for valuing a stock or business. Often used to provide difficult-to-resolve valuation issues for litigation, tax planning, and business transactions that don't have an explicit market value. It is named after Myron J....

    )
  • 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
Debt to equity ratio
The debt-to-equity ratio is a financial ratio indicating the relative proportion of shareholders' equity and debt used to finance a company's assets. Closely related to leveraging, the ratio is also known as Risk, Gearing or Leverage...

 and the current ratio (current assets/current liabilities).

The simple model commonly used is the Price/Earnings
P/E ratio
The P/E ratio of a stock is a measure of the price paid for a share relative to the annual net income or profit earned by the firm per share...

 ratio. Implicit in this model of a perpetual annuity (Time value of money
Time value of money
The time value of money is the value of money figuring in a given amount of interest earned over a given amount of time. The time value of money is the central concept in finance theory....

) 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
PEG ratio
The PEG ratio is a valuation metric for determining the relative trade-off between the price of a stock, the earnings generated per share , and the company's expected growth....

, but the math does not hold up to analysis. Its validity depends on the length of time you think the growth will continue. IGAR models can be used to impute expected changes in growth from current P/E and historical growth rates for the stocks relative to a comparison index.

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.

Criticisms

  • Economists such as Burton Malkiel
    Burton Malkiel
    Burton Gordon Malkiel is an American economist and writer, most famous for his classic finance book A Random Walk Down Wall Street...

     suggest that neither fundamental analysis nor technical analysis
    Technical analysis
    In finance, technical analysis is security analysis discipline for forecasting the direction of prices through the study of past market data, primarily price and volume. Behavioral economics and quantitative analysis incorporate technical analysis, which being an aspect of active management stands...

     is useful in outperforming the markets

See also

  • Lists of valuation topics
  • Stock picking
  • Security analysis
    Security analysis
    Security analysis is the analysis of tradeable financial instruments called securities. These can be classified into debt securities, equities, or some hybrid of the two. More broadly, futures contracts and tradeable credit derivatives are sometimes included...

  • Stock selection criterion
  • John Burr Williams: Theory
  • Mosaic theory
    Mosaic theory
    Mosaic theory, also referred to more colloquially as the scuttlebutt method by Philip Fisher in his seminal work Common Stocks and Uncommon Profits, in finance is the method used in security analysis to gather information about a corporation. Mosaic theory involves collecting information from...

  • Chepakovich valuation model
    Chepakovich valuation model
    The Chepakovich valuation model uses the discounted cash flow valuation approach. It was first developed by Alexander Chepakovich in 2000 and perfected in subsequent years...


External links

The source of this article is wikipedia, the free encyclopedia.  The text of this article is licensed under the GFDL.
 
x
OK