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Fundamental analysis, in accounting and finance, is the analysis of a business's
financial statement Financial statements (or financial reports) are formal records of the financial activities and position of a business, person, or other entity. Relevant financial information is presented in a structured manner and in a form which is easy to un ...
s (usually to analyze the business's
asset In financial accounting, an asset is any resource owned or controlled by a business or an economic entity. It is anything (tangible or intangible) that can be used to produce positive economic value. Assets represent value of ownership that ca ...
s, liabilities, and earnings); health; and competitors and markets. It also considers the overall state of the economy and factors including interest rates, production, earnings, employment, GDP, housing, manufacturing and management. There are two basic approaches that can be used: bottom up analysis and top down analysis. These terms are used to distinguish such analysis from other types of investment analysis, such as
quantitative Quantitative may refer to: * Quantitative research, scientific investigation of quantitative properties * Quantitative analysis (disambiguation) * Quantitative verse, a metrical system in poetry * Statistics, also known as quantitative analysis ...
and
technical Technical may refer to: * Technical (vehicle), an improvised fighting vehicle * Technical analysis, a discipline for forecasting the future direction of prices through the study of past market data * Technical drawing, showing how something is co ...
. 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 and predict its probable price evolution; * to make a projection on its business performance; * to evaluate its management and make internal business decisions and/or to calculate its credit risk; * to find out the intrinsic value of the share.


The two analytical models

There are two basic methodologies investors rely upon when the objective of the analysis is to determine what stock to buy and at what price: #Fundamental analysis. Analysts maintain that markets may incorrectly price a security in the short run but the "correct" price will eventually be reached. Profits can be made by purchasing the wrongly priced security and then waiting for the market to recognize its "mistake" and reprice the security. #
Technical analysis In finance, technical analysis is an analysis methodology for analysing and forecasting the direction of prices through the study of past market data, primarily price and volume. Behavioral economics and quantitative analysis use many of the sa ...
. Analysts look at trends and price levels and believe that trend changes confirm sentiment changes. Recognizable price chart patterns may be found due to investors' emotional responses to price movements. Technical analysts mainly evaluate historical trends and ranges to predict future price movement. Investors can use one or both of these complementary methods for stock picking. For example, many fundamental investors use technical indicators for deciding entry and exit points. Similarly, a large proportion of technical investors use fundamental indicators to limit their pool of possible stocks 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". For explanations of these paradigms, see the discussions at
efficient-market hypothesis The efficient-market hypothesis (EMH) is a hypothesis in financial economics that states that asset prices reflect all available information. A direct implication is that it is impossible to "beat the market" consistently on a risk-adjusted b ...
, random walk hypothesis,
capital asset pricing model In finance, the capital asset pricing model (CAPM) is a model used to determine a theoretically appropriate required rate of return of an asset, to make decisions about adding assets to a well-diversified portfolio. The model takes into ac ...
, Fed model Theory of Equity Valuation,
market-based valuation A Market-based valuation is a form of stock valuation that refers to market indicators, also called extrinsic criteria (i.e. not related to economic fundamentals and account data, which are intrinsic criteria). Examples of market valuation methods ...
, and behavioral finance. Fundamental analysis includes: #Economic analysis #Industry analysis #Company analysis The intrinsic value of the shares is determined based upon these three analyses. It is this value that is considered the true value of the share. If the intrinsic value is higher than the market price, buying the share is recommended. If it is equal to market price, it is recommended to hold the share; and if it is less than the market price, then one should sell the shares.


Use by different portfolio styles

Investors may also use fundamental analysis within different portfolio
management Management (or managing) is the administration of an organization, whether it is a business, a nonprofit organization, or a government body. It is the art and science of managing resources of the business. Management includes the activities ...
styles. * Buy and hold investors believe that latching on to 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 the probability of wipe-out. * Value investors restrict their attention to under-valued companies, believing that "it's hard to fall out of a ditch". The values they follow come from fundamental analysis. *Managers may use fundamental analysis to correctly value "good" and "bad" companies. *Managers may also consider the economic cycle in determining whether conditions are "right" to buy fundamentally suitable companies. * Contrarian investors hold that "in the short run, the market is a voting machine, not a weighing machine". Fundamental analysis allows an investor to make his or her own decision on value, while ignoring the opinions of the market. *Managers may use fundamental analysis to determine future growth rates for buying high priced growth stocks. *Managers may include fundamental factors along with technical factors in computer models (
quantitative analysis Quantitative analysis may refer to: * Quantitative research, application of mathematics and statistics in economics and marketing * Quantitative analysis (chemistry), the determination of the absolute or relative abundance of one or more substanc ...
).


Top-down and bottom-up approaches

Investors using fundamental analysis can use either a top-down or bottom-up approach. *The top-down investor starts their analysis with global economics, including both international and national economic indicators. These may include GDP growth rates,
inflation In economics, inflation is an increase in the general price level of goods and services in an economy. When the general price level rises, each unit of currency buys fewer goods and services; consequently, inflation corresponds to a reductio ...
,
interest rate An interest rate is the amount of interest due per period, as a proportion of the amount lent, deposited, or borrowed (called the principal sum). The total interest on an amount lent or borrowed depends on the principal sum, the interest rate, t ...
s, exchange rates,
productivity Productivity is the efficiency of production of goods or services expressed by some measure. Measurements of productivity are often expressed as a ratio of an aggregate output to a single input or an aggregate input used in a production proce ...
, and energy prices. They subsequently narrow their search 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 do they refine their search to the best business in the area being studied. *The bottom-up investor starts with specific businesses, regardless of their industry/region, and proceeds in reverse of the top-down approach.


Procedures

The analysis of a business's health starts with a financial statement analysis that includes financial 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 Thomson Reuters Corporation ( ) is a Canadian multinational media conglomerate. The company was founded in Toronto, Ontario, Canada, where it is headquartered at the Bay Adelaide Centre. Thomson Reuters was created by the Thomson Corp ...
and others can be considered either "fundamental" (they are facts) or "technical" (they are investor sentiment) based on perception of their validity. 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: *
dividend A dividend is a distribution of profits by a corporation to its shareholders. When a corporation earns a profit or surplus, it is able to pay a portion of the profit as a dividend to shareholders. Any amount not distributed is taken to be re-inv ...
s received by the investor, along with the eventual sale price; (
Gordon model In finance and investing, the dividend discount model (DDM) is a method of valuing the price of a company's stock based on the fact that its stock is worth the sum of all of its future dividend payments, discounted back to their present value. In ...
) *earnings of the company; *or
cash flow A cash flow is a real or virtual movement of money: *a cash flow in its narrow sense is a payment (in a currency), especially from one central bank account to another; the term 'cash flow' is mostly used to describe payments that are expected ...
s of the company. The simple model commonly used is the P/E ratio (price-to-earnings ratio). Implicit in this model of a perpetual annuity ( time value of money) is that the inverse, or the E/P rate, is the discount rate appropriate to the risk of the business. Usage of the P/E ratio has the disadvantage that it ignores future earnings growth. Because the future growth of the free cash flow and earnings of a company drive the fair value of the company, the PEG ratio is more meaningful than the P/E ratio. The PEG ratio incorporates the growth estimates for future earnings, e.g. of the EBIT. Its validity depends on the length of time analysts believe the growth will continue and on the reasonableness of future estimates compared to earnings growth in the past years (oftentimes the last seven years). 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. The amount of debt a company possesses is also a major consideration in determining its financial leverage and its health. This is meaningful because a company can reach higher earnings (and this way a higher return on equity and higher P/E ratio) simply by increasing the amount of net debt. This can be quickly assessed using the debt-to-equity ratio, the current ratio (current assets/current liabilities) and the return on capital employed (ROCE). The ROCE is the ratio of EBIT divided by the "capital employed", i.e. all the current and non-current assets less the operating liabilities, which is the real capital of the company no matter if it is financed by equity or debt.


Criticisms

Economists such as Burton Malkiel suggest that neither fundamental analysis nor
technical analysis In finance, technical analysis is an analysis methodology for analysing and forecasting the direction of prices through the study of past market data, primarily price and volume. Behavioral economics and quantitative analysis use many of the sa ...
is useful in outperforming the markets.


See also

* Stock valuation * Lists of valuation topics * Security analysis *
Piotroski F-score Piotroski F-score is a number between 0 and 9 which is used to assess strength of company's financial position. The score is used by financial investors in order to find the best value stocks (nine being the best). The score is named after Stanford ...
* Stock selection criterion * John Burr Williams#Theory * Mosaic theory * Chepakovich valuation model * Fundamental Analysis Software * Financial forecast


References


External links


MIT Financial-Management course notesFundamental Analysis Works
{{DEFAULTSORT:Fundamental Analysis Commodity markets Derivatives (finance) Foreign exchange market Stock market