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Overview of Fundamental Analysis




Fundamental analysis of a business involves analyzing its income statement, financial statements and health, its management and competitive advantages, and its competitors and markets.

The analysis is performed on historical and present data, but with the goal to make financial projections. There are several possible objectives:

  • to conduct a company stock valuation and predict its probable price evolution,
  • to make projection on its business performance,
  • to evaluate its management and make internal business decisions,
  • to calculate its credit 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 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, so fundamental analysis is a waste of time. 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 both these different but somewhat complementary methods for stock picking. 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, and behavioral finance.

Use by different portfolio styles

Investors may use fundamental analysis within different portfolio management styles.

  • 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' company's stock goes up and down, creating opportunities for profits.
  • Contrarian investors distinguish "in the short run, the market is a voting machine, not a weighing machine"[1]. 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.
  • 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).

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 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 does he narrow 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. 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 Financial 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

  • dividends received by the investor, along with the eventual sale price. (Gordon model)
  • earnings of the company, or
  • cash flows of the company.

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. 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.[2]

Criticisms

  • Some economists such as Burton Malkiel suggest that neither fundamental analysis nor technical analysis is useful in outperforming the markets[3]

References

  1. Security Analysis
  2. investopedia.com. Investopedia: Quant Fund
  3. investopedia.com.Financial Concepts: Random Walk Theory

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