Fundamental analysis
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Fundamental analysis, in
accounting Accounting, also known as accountancy, is the process of recording and processing information about economic entity, economic entities, such as businesses and corporations. Accounting measures the results of an organization's economic activit ...
and
finance Finance refers to monetary resources and to the study and Academic discipline, discipline of money, currency, assets and Liability (financial accounting), liabilities. As a subject of study, is a field of Business administration, Business Admin ...
, 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 can b ...
s, liabilities, and
earnings {{Short description, Financial term Earnings are the net benefits of a corporation's operation. Earnings is also the amount on which corporate tax is due. For an analysis of specific aspects of corporate operations several more specific terms are u ...
); health;
competitors Competition is a rivalry where two or more parties strive for a common goal which cannot be shared: where one's gain is the other's loss (an example of which is a zero-sum game). Competition can arise between entities such as organisms, indi ...
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
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. As a type of active management, it stands in contradiction to ...
. 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 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 � ...
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 Credit risk is the chance that a borrower does not repay a loan In finance, a loan is the tender of money by one party to another with an agreement to pay it back. The recipient, or borrower, incurs a debt and is usually required to pay ...
; * 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 or selling 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. As a type of active management, it stands in contradiction to ...
. 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 basis ...
, 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 Diversification (finance), well-diversified Portfolio (f ...
, Fed model, market-based valuation, 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 organizations, whether businesses, nonprofit organizations, or a Government agency, government bodies through business administration, Nonprofit studies, nonprofit management, or the political s ...
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 stock In finance, a growth stock is a stock of 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. A growth c ...
s. *Managers may include fundamental factors along with technical factors in computer models ( quantitative analysis).


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 indicator An economic indicator is a statistic about an Economics, economic activity. Economic indicators allow analysis of economic performance and predictions of future performance. One application of economic indicators is the study of business cycles. ...
s. These may include GDP growth rates,
inflation In economics, inflation is an increase in the average price of goods and services in terms of money. This increase is measured using a price index, typically a consumer price index (CPI). When the general price level rises, each unit of curre ...
,
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, ...
s,
exchange rate In finance, an exchange rate is the rate at which one currency will be exchanged for another currency. Currencies are most commonly national currencies, but may be sub-national as in the case of Hong Kong or supra-national as in the case of ...
s,
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 ratio A financial ratio or accounting ratio states the 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 fin ...
s. 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 corporation, multinational content-driven technology Conglomerate (company), conglomerate. The company was founded in Toronto, Ontario, Canada, and maintains its headquarters at 1 ...
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 The discounted cash flow (DCF) analysis, in financial analysis, is a method used to value a security, project, company, or asset, that incorporates the time value of money. Discounted cash flow analysis is widely used in investment finance, re ...
model, which calculates the present value of the future: *
dividend A dividend is a distribution of profits by a corporation to its shareholders, after which the stock exchange decreases the price of the stock by the dividend to remove volatility. The market has no control over the stock price on open on the ex ...
s received by the investor, along with the eventual sale price; ( Gordon model) *earnings of the company; *or
cash flow Cash flow, in general, refers to payments made into or out of a business, project, or financial product. It can also refer more specifically to a real or virtual movement of money. *Cash flow, in its narrow sense, is a payment (in a currency), es ...
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 The time value of money refers to the fact that there is normally a greater benefit to receiving a sum of money now rather than an identical sum later. It may be seen as an implication of the later-developed concept of time preference. The time ...
) 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 The return on equity (ROE) is a measure of the profitability of a business in relation to its equity; where: : Jason Fernando (2023)"Return on Equity (ROE) Calculation and What It Means" Investopedia Thus, ROE is equal to a fiscal year's net in ...
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 Burton Gordon Malkiel (born August 28, 1932) is an American economist, financial executive, and writer most noted for his classic finance book ''A Random Walk Down Wall Street'' (first published 1973, in its 13th edition as of 2023). Malkiel i ...
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. As a type of active management, it stands in contradiction to ...
is useful in outperforming the markets.


See also

*
Financial forecast A financial forecast is an estimate of future financial outcomes for a company or project, usually applied in budgeting, capital budgeting and/or valuation. Depending on context, the term may also refer to listed company (quarterly) earnings gui ...
* Intermediated research * Lists of valuation topics * Mosaic theory * Piotroski F-score * Security analysis * Stock selection criterion *
Stock valuation 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 � ...
* John Burr Williams#Theory


References


External links


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