Fundamental analysis

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Fundamental analysis, in accounting and finance, is the analysis of a business's financial statements (usually to analyze the business's assets, liabilities, and earnings); health; [1] 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. [2] These terms are used to distinguish such analysis from other types of investment analysis, such as quantitative and technical.

Asset economic resource, from which future economic benefits are expected

In financial accounting, an asset is any resource owned by the business. Anything tangible or intangible that can be owned or controlled to produce value and that is held by a company to produce positive economic value is an asset. Simply stated, assets represent value of ownership that can be converted into cash. The balance sheet of a firm records the monetary value of the assets owned by that firm. It covers money and other valuables belonging to an individual or to a business.

Liability (financial accounting) sum of the equity and the liabilities

In financial accounting, a liability is defined as the future sacrifices of economic benefits that the entity is obliged to make to other entities as a result of past transactions or other past events, the settlement of which may result in the transfer or use of assets, provision of services or other yielding of economic benefits in the future.

Contents

Fundamental analysis is performed on historical and present data, but with the goal of making financial forecasts. There are several possible objectives:

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 from price movement – stocks that are judged undervalued are bought, while stocks that are judged overvalued are sold, in the expectation that undervalued stocks will overall rise in value, while overvalued stocks will generally decrease in value.

A credit risk is the 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 collection costs. The loss may be complete or partial. In an efficient market, higher levels of credit risk will be associated with higher borrowing costs. Because of this, measures of borrowing costs such as yield spreads can be used to infer credit risk levels based on assessments by market participants.

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, :

  1. Fundamental analysis maintains that markets may incorrectly price a security in the short run but that 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.
  2. Technical analysis maintains that all information is reflected already in the price of a security. Technical analysts look at trends and believe that sentiment changes predate and predict trend changes. Investors' emotional responses to price movements lead to recognizable price chart patterns. Technical analysts also evaluate historical trends to predict future price movement. [4]

Investors can use one or both of these complementary methods for stock picking. For example, many fundamental investors use technicals for deciding entry and exit points. Similarly, a large proportion of 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".For explanations of these paradigms, see the discussions at efficient-market hypothesis, random walk hypothesis, capital asset pricing model, Fed model Theory of Equity Valuation, market-based valuation, and behavioral finance.

The efficient-market hypothesis (EMH) is a theory in financial economics that states that asset prices fully reflect all available information. A direct implication is that it is impossible to "beat the market" consistently on a risk-adjusted basis since market prices should only react to new information.

The random walk hypothesis is a financial theory stating that stock market prices evolve according to a random walk and thus cannot be predicted. It is consistent with the efficient-market 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.

Fundamental analysis includes:

  1. Economic analysis
  2. Industry analysis
  3. 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 styles.

In finance, a portfolio is a collection of investments held by an investment company, hedge fund, financial institution or individual.

Investment management is the professional asset management of various securities and other assets in order to meet specified investment goals for the benefit of the investors. Investors may be institutions or private investors.

An investor profile or style defines an individual's preferences in investment decisions, for example:

Buy and hold, also called position trading, is an investment strategy where an investor buys stocks and holds them for a long time, with the goal that stocks will gradually increase in value over a long period of time.

Value investing is an investment paradigm that involves buying securities that appear underpriced by some form of fundamental analysis. The various forms of value investing derive from the investment philosophy first taught by Benjamin Graham and David Dodd at Columbia Business School in 1928, and subsequently developed in their 1934 text Security Analysis.

Contrarian Investing is an investment strategy that is characterized by purchasing and selling in contrast to the prevailing sentiment of the time.

Top-down and bottom-up approaches

Investors using fundamental analysis can use either a top-down or bottom-up 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 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:

The amount of debt a company possesses is also a major consideration in determining its health. It can be quickly assessed using the debt-to-equity ratio and the current ratio (current assets/current liabilities).

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 "flip" of the P/E is the discount rate appropriate to the risk of the business. The multiple accepted is adjusted for expected growth (which is not built into the model).

Growth estimates are incorporated into the PEG ratio. Its validity depends on the length of time analysts believe the growth will continue. 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.

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 the year 2000, a new job role has been invented with computers now able to crunch vast amounts of data . At some funds (Quant Funds) managers' decisions have been replaced by proprietary mathematical models.

Automation

The process of fundamental analysis has significantly dropped in difficulty over the past 10 years. Ever since computers became a household product, people have built software designed to make the investor's life easier. Fundamental analysis is one of the most time consuming forms of analysis. Furthermore, with the fast paced trading style of the 21st century, where markets are dominated by HFT firms and day traders, it is difficult to keep up with the market in a timely fashion. One way to go about cutting down analysis time, is to subscribe to either free or paid screening services. Screening services will allow you to search the entire market for stocks that match the quantitative fields you are looking for. These types of software then automatically give you results, hence cutting down on time spent sifting through SEC filings.

Reference - Fundamental Analysis Software for more information on fundamental analysis software.

Criticisms

See also

Related Research Articles

Equity (finance) difference between the value of the assets/interest and the cost of the liabilities of something owned

In accounting, equity is the difference between the value of the assets and the value of the liabilities of something owned. It is governed by the following equation:

Price–earnings ratio

The price/earnings ratio is the ratio of a company's share (stock) price to the company's earnings per share. The ratio is used for valuing companies and to find out whether they are overvalued or undervalued.

In accounting, book value is the value of an asset according to its balance sheet account balance. For assets, the value is based on the original cost of the asset less any depreciation, amortization or impairment costs made against the asset. Traditionally, a company's book value is its total assets minus intangible assets and liabilities. However, in practice, depending on the source of the calculation, book value may variably include goodwill, intangible assets, or both. The value inherent in its workforce, part of the intellectual capital of a company, is always ignored. When intangible assets and goodwill are explicitly excluded, the metric is often specified to be "tangible book value".

Valuation (finance) process of estimating what something is worth, used in the finance industry

In finance, valuation is the process of determining the present value (PV) of an asset. Valuations can be done on assets or on liabilities. Valuations are needed for many reasons such as investment analysis, capital budgeting, merger and acquisition transactions, financial reporting, taxable events to determine the proper tax liability, and in litigation.

Enterprise value (EV), total enterprise value (TEV), or firm value (FV) is an economic measure reflecting the market value of a business. It is a sum of claims by all claimants: creditors and shareholders. Enterprise value is one of the fundamental metrics used in business valuation, financial modeling, accounting, portfolio analysis, and risk analysis.

In corporate finance, the return on equity (ROE) is a measure of the profitability of a business in relation to the equity, also known as net assets or assets minus liabilities. ROE is a measure of how well a company uses investments to generate earnings growth.

Business valuation is a process and a set of procedures used to estimate the economic value of an owner's interest in a business. Valuation is used by financial market participants to determine the price they are willing to pay or receive to effect a sale of a business. In addition to estimating the selling price of a business, the same valuation tools are often used by business appraisers to resolve disputes related to estate and gift taxation, divorce litigation, allocate business purchase price among business assets, establish a formula for estimating the value of partners' ownership interest for buy-sell agreements, and many other business and legal purposes such as in shareholders deadlock, divorce litigation and estate contest. In some cases, the court would appoint a forensic accountant as the joint expert doing the business valuation.

John Burr Williams was an American economist, recognized as an important figure in the field of fundamental analysis, and for his analysis of stock prices as reflecting their "intrinsic value." He is best known for his 1938 text The Theory of Investment Value, based on his Ph.D. thesis, in which he articulated the theory of discounted cash flow (DCF) based valuation, and in particular, dividend based valuation.

In economics, valuation using multiples is a process that consists of:

Financial statement analysis

Financial statement analysis is the process of reviewing and analyzing a company's financial statements to make better economic decisions to earn income in future. These statements include the income statement, balance sheet, statement of cash flows, notes to accounts and a statement of changes in equity(if applicable). Financial statement analysis is a method or process involving specific techniques for evaluating risks, performance, financial health, and future prospects of an organization.

The following outline is provided as an overview of and topical guide to finance:

Relative valuation also called valuation using multiples is the notion of comparing the price of an asset to the market value of similar assets. In the field of securities investment, the idea has led to important practical tools, which could presumably spot pricing anomalies. These tools have subsequently become instrumental in enabling analysts and investors to make vital decisions on asset allocation.

Quality investing is an investment strategy based on a set of clearly defined fundamental criteria that seeks to identify companies with outstanding quality characteristics. The quality assessment is made based on soft and hard criteria. Quality investing supports best overall rather than best-in-class approach.

Chepakovich valuation model

The Chepakovich valuation model uses the discounted cash flow valuation approach. It was first developed by Alexander Chepakovich in 2000 and perfected in subsequent years. The model was originally designed for valuation of “growth stocks” and is successfully applied to valuation of high-tech companies, even those that do not generate profit yet. At the same time, it is a general valuation model and can also be applied to no-growth or negative growth companies. In a limiting case, when there is no growth in revenues, the model yields similar valuation result as a regular discounted cash flow to equity model.

A share price is the price of a single share of a number of saleable stocks of a company, derivative or other financial asset. In layman's terms, the stock price is the highest amount someone is willing to pay for the stock, or the lowest amount that it can be bought for.

Macro risk is financial risk that is associated with macroeconomic or political factors. There are at least three different ways this phrase is applied. It can refer to economic or financial risk found in stocks and funds, to political risk found in different countries, and to the impact of economic or financial variables on political risk. Macro risk can also refer to types of economic factors which influence the volatility over time of investments, assets, portfolios, and the intrinsic value of companies.

Corporate finance area of finance dealing with the sources of funding and the capital structure of corporations

Corporate finance is an area of finance that deals with sources of funding, the capital structure of corporations, the actions that managers take to increase the value of the firm to the shareholders, and the tools and analysis used to allocate financial resources. The primary goal of corporate finance is to maximize or increase shareholder value. Although it is in principle different from managerial finance which studies the financial management of all firms, rather than corporations alone, the main concepts in the study of corporate finance are applicable to the financial problems of all kinds of firms.

References

  1. "Technical Analysis vs. Fundamental Analysis". Market Technicians Association . Retrieved 6 March 2015.
  2. "An Introduction to Fundamental Analysis and the US Economy". InformedTrades.com. 2008-02-14. Retrieved 2009-07-27.
  3. "Fundamental and Technical analysis | Fundamentals of Accounting". 2016-07-07. Retrieved 2016-07-07.
  4. Murphy, John J. (1999). Technical analysis of the financial markets : a comprehensive guide to trading methods and applications (2nd ed.). New York [u.a.]: New York Institute of Finance. ISBN   0735200661.
  5. Graham, Benjamin; Dodd, David (December 10, 2004). Security Analysis. McGraw-Hill. ISBN   978-0-07-144820-8.
  6. "Financial Concepts: Random Walk Theory". Investopedia.
  7. Dzanic, Enis (2013-05-10). "Correlation of Change in Fundamental Indicators and Stock Price Movements on Sarajevo Stock Exchange". Rochester, NY.