Fundamental analysis
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Fundamental analysis is a security or stock valuation method that uses financial and economic analysis to predict the movement of security prices such as bond prices, but more commonly stock prices. The fundamental information that is analyzed can include a company's financial reports, and non-finanical information such as estimates of the growth of demand for competing products, industry comparisons, analysis of the effects of new regulations or demographic changes, and economy-wide changes. It is commonly contrasted with so-called technical analysis which analyzes security price movements without reference to factors outside of the market itself.
A potential (or current) investor uses fundamental analysis to examine a company's financial results, its operations and the market(s) in which the company is competing to understand the stability and growth potential of that company. Company factors to consider might include dividends paid, the way a company manages its cash, the amount of debt a company has, and the growth of a company's revenues, expenses and earnings. A fundamental analyst may enter long or short positions based on the result of fundamental analysis.
The theory underpinning fundamental analysis is that, to truly make money in the long run, an investor must focus on the company itself rather than merely on the movement of its stock price. As Benjamin Graham and David Dodd say in their classic work Security Analysis, "in the short run, the market is a voting machine, not a weighing machine." An investor uses fundamental analysis to find the companies that are built to last.
Fundamental analysis adherents believe a company's "intrinsic value" will eventually be reflected in the stock price through market forces, but that, while the market is ultimately efficient, some stocks (for any number of reasons) are either over- or under-valued in the short run.
To this end, earnings multiples, such as the P/E ratio, may be used to determine value, where cash flows are relatively stable and predictable. An important caveat here is that the P/E ratio is ultimately not an objective measure because it must be interpreted; a high P/E ratio might show an overvalued stock, or it might reflect a company with high potential for growth. One method for combatting this interpretation problem is to use the valuation equations in the works of Aswath Damodaran or on web sites like ValueTool ([1]) that interpret equations such as P/E, P/BV, or FCFE as dollar values, so that they may be easily compared to the stock price.
Other valuation techniques include discounted cash flow, book value, and dividend yield analysis.
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Three step process
In large organizations fundamental analysis is usually performed in three steps:
- analysis of the macroeconomic situation, usually including forecasts for both international and national GDP growth rates, inflation, interest rates, exchange rates, productivity, and energy prices.
- industry analysis, usually including forecasts of total sales, price levels, the effects of competing products, foreign competition, and entry or exit from the industry.
- individual firm analysis, usually including forecasts of unit sales, prices, new products, earnings, and the possibilities of new debt or equity issues.
Often the procedure stresses the effects of the overall economic situation on industry and firm analysis and is known as top down analysis. If instead the procedure stresses firm analysis and uses it to build its industry analysis, which it uses to build its macroeconomic analysis, it is known as bottom up analysis.
Criticisms
- Some economists such as Burton Malkiel suggest that neither fundamental analysis nor technical analysis is useful in outperforming the markets<ref>investopedia.com. Financial Concepts: Random Walk Theory</ref> (see efficient market hypothesis and random walk hypothesis).
References
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