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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 can ...
s, liabilities, and
earnings 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 used as EBIT (earnings before intere ...
); health; and
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, indivi ...
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 In finance, valuation is the process of determining the present value (PV) of an asset. In a business context, it is often the hypothetical price that a third party would pay for a given asset. Valuations can be done on assets (for example, inve ...
, such as quantitative and technical. Fundamental analysis is performed on historical and present data, but with the goal of making financial
forecasts Forecasting is the process of making predictions based on past and present data. Later these can be compared (resolved) against what happens. For example, a company might estimate their revenue in the next year, then compare it against the actual ...
. There are several possible objectives: * to conduct a company
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 fr ...
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 A credit risk is risk of default on a debt that may arise from a borrower failing to make required payments. In the first resort, the risk is that of the lender and includes lost principal and interest, disruption to cash flows, and increased ...
; * 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 sam ...
. 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 bas ...
, random walk hypothesis, capital asset pricing model,
Fed model The "Fed model" or "Fed Stock Valuation Model" (FSVM), is a disputed theory of equity valuation that compares the stock market's forward earnings yield to the nominal yield on long-term government bonds, and that the stock market – as a whole ...
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 Behavioral economics studies the effects of psychological, cognitive, emotional, cultural and social factors on the decisions of individuals or institutions, such as how those decisions vary from those implied by classical economic theory. ...
. 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 Portfolio may refer to: Objects * Portfolio (briefcase), a type of briefcase Collections * Portfolio (finance), a collection of assets held by an institution or a private individual * Artist's portfolio, a sample of an artist's work or a c ...
management Management (or managing) is the administration of an organization, whether it is a business, a nonprofit organization, or a Government agency, government body. It is the art and science of managing resources of the business. Management includ ...
styles. *
Buy and hold Buy and hold, also called position trading, is an investment strategy whereby an investor buys financial assets or non-financial assets such as real estate, to hold them long term, with the goal of realizing price appreciation, despite volatilit ...
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).


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 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. Economic ...
s. These may include
GDP Gross domestic product (GDP) is a monetary measure of the market value of all the final goods and services produced and sold (not resold) in a specific time period by countries. Due to its complex and subjective nature this measure is ofte ...
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 reduct ...
,
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 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 proces ...
, 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 Corpora ...
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-i ...
s 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 P/E ratio (price-to-earnings ratio). Implicit in this model of a perpetual annuity (
time value of money The time value of money is the widely accepted conjecture that there is 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 ...
) 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 The 'PEG ratio' ( price/earnings to growth ratio) is a valuation metric for determining the relative trade-off between the price of a stock, the earnings generated per share ( EPS), and the company's expected growth. In general, the P/E ratio is ...
is more meaningful than the P/E ratio. The
PEG ratio The 'PEG ratio' ( price/earnings to growth ratio) is a valuation metric for determining the relative trade-off between the price of a stock, the earnings generated per share ( EPS), and the company's expected growth. In general, the P/E ratio is ...
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 the equity. Because shareholder's equity can be calculated by taking all assets and subtracting all liabilities, ROE can also be thought of as a return on ''a ...
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 debt-to-equity ratio (D/E) 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. The two ...
, the
current ratio The current ratio is a liquidity ratio that measures whether a firm has enough resources to meet its short-term obligations. It compares a firm's current assets to its current liabilities, and is expressed as follows:- : The current ratio is an ...
(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 and writer most noted for his classic finance book '' A Random Walk Down Wall Street'' (first published 1973, in its 12th edition as of 2019). He is a leading proponent of the e ...
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 sam ...
is useful in outperforming the markets.


See also

*
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 fr ...
* Lists of valuation topics * Security analysis * Piotroski F-score * Stock selection criterion * John Burr Williams#Theory * Mosaic theory * Chepakovich valuation model *
Fundamental Analysis Software Fundamental analysis software automates analysis that supports fundamental analysts in their review of a company's financial statements and valuation. Features The following are the most common features of fundamental analysis applications. Bac ...
*
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; see . Depending on context the term may also refer to listed company (quarterly) ea ...


References


External links


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