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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 Financial accounting is the field of accounting Accounting or Accountancy is the measurement, processing, and communication of financial and non financial information about economic entity, economic entities such a ...
s,
liabilities Liability may refer to: Law * Legal liability, in both civil and criminal law ** Public liability, part of the law of tort which focuses on civil wrongs ** Product liability, the area of law in which manufacturers, distributors, suppliers, reta ...
, and
earnings Earnings are the net benefits of a corporation A corporation is an organization—usually a group of people or a company—authorized by the State (polity), state to act as a single entity (a legal entity recognized by private and public law ...
); health; and competitors and
markets Market may refer to: *Market (economics) *Market economy *Marketplace, a physical marketplace or public market Geography *Märket, an island shared by Finland and Sweden Art, entertainment, and media Films *Market (1965 film), ''Market'' (1965 ...
. 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 Finance is the study of financial institutions, financial markets and how they operate within the financial system. It is concerned with the creation and management of money and investments. Savers and investors have money availabl ...
, such as quantitative 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 con ...

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 and most commonly by analysis of trends. A commonplace example might be estimation of some variable of interest at some specified future date. Prediction is a similar, ...
. There are several possible objectives: * to conduct a company
stock valuationIn 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 fro ...
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 Default may refer to: Law * Default (law), the failure to do something required by law ** Default (finance) In finance Finance is the study of financial institutions, financial markets and how they ope ...
; * 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 forecasting the direction of prices through the study of past market data, primarily price and volume. Behavioral economics and Quantitative analysis (finance), quantitative analysis us ...

Technical analysis
. 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 Financial economics is the branch of economics characterized by a "concentration on monetary activities", in which "money of one type or another is likely to appear o ...
,
random walk hypothesisThe random walk hypothesis is a financial theory stating that stock market A stock market, equity market, or share market is the aggregation of buyers and sellers of stocks (also called shares), which represent ownership claims on busine ...
,
capital asset pricing model In finance Finance is a term for the management, creation, and study of money In a 1786 James Gillray caricature, the plentiful money bags handed to King George III are contrasted with the beggar whose legs and arms were amputated, i ...
,
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 interest rate, nominal yield on long-term government bonds, and that the stock m ...
Theory of Equity Valuation,
market-based valuationA Market-based valuation is a form of stock valuationIn 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 gener ...
, and
behavioral finance Behavioral economics (also, behavioural economics) studies the effects of psychological Psychology is the scientific Science () is a systematic enterprise that Scientific method, builds and organizes knowledge in the form of Te ...
. 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) In finance, a portfolio is a collection of investments To invest is to allocate money Image:National-Debt-Gillray.jpeg, ...
management Management (or managing) is the administration of an organization An organization, or organisation (Commonwealth English The use of the English language English is a West Germanic languages, West Germanic language first spok ...
styles Style is a manner of doing or presenting things and may refer to: * Architectural style, the features that make a building or structure historically identifiable * Design, the process of creating something * Fashion, a prevailing mode of clothing s ...
. *
Buy and holdBuy and hold, also called position trading, is an investment strategyIn finance Finance is the study of financial institutions, financial markets and how they operate within the financial system. It is concerned with the creation and management ...
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 stockIn finance Finance is the study of financial institutions, financial markets and how they operate within the financial system. It is concerned with the creation and management of money and investments. Savers and investors have money available w ...
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 A statistic (singular) or sample statistic is any quantity computed from values in a sample which is considered for a statistical purpose. Statistical purposes include estimating a population Popula ...
s. These may include
GDP Gross domestic product (GDP) is a monetary Image:National-Debt-Gillray.jpeg, In a 1786 James Gillray caricature, the plentiful money bags handed to King George III are contrasted with the beggar whose legs and arms were amputated, in the ...
growth rates,
inflation In economics, inflation refers to a general progressive increase in prices 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 r ...

inflation
,
interest rate An interest rate is the amount of interest In and , interest is payment from a or deposit-taking financial institution to a or depositor of an amount above repayment of the (that is, the amount borrowed), at a particular rate. It is disti ...
s,
exchange rate In finance Finance is a term for the management, creation, and study of money In a 1786 James Gillray caricature, the plentiful money bags handed to King George III are contrasted with the beggar whose legs and arms were amputated, ...
s,
productivity Productivity is the efficiency Efficiency is the (often measurable) ability to avoid wasting materials, energy, efforts, money, and time in doing something or in producing a desired result. In a more general sense, it is the ability to do th ...
, 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 is a relative magnitude of two selected numerical values taken from an enterprise's financial statement Financial statements (or financial reports) are formal records of the financial activities and positi ...
s. It looks at dividends paid,
operating cash flowIn financial accounting Financial accounting is the field of accounting Accounting or Accountancy is the measurement, processing, and communication of financial and non financial information about economic entity, economic entities such as bu ...
, new equity issues and capital financing. The earnings estimates and growth rate projections published widely by
Thomson Reuters Thomson Reuters Corporation () is a Canadian-American multinational Multinational may refer to: * Multinational corporation, a corporate organization operating in multiple countries * Multinational force, a military body from multiple co ...
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 In finance Finance is the study of financial institutions, financial markets and how they operate within the financial system. It is concerned with the creation and management of money and investments. Savers and investors have money available ...
model, which calculates the present value of the future: *
dividend A dividend is a distribution of profit Profit may refer to: Business and law * Profit (accounting), the difference between the purchase price and the costs of bringing to market * Profit (economics), normal profit and economic profit * Profit ...

dividend
s received by the investor, along with the eventual sale price; (
Gordon model In finance Finance is the study of financial institutions, financial markets and how they operate within the financial system. It is concerned with the creation and management of money and investments. Savers and investors have money available ...
) *earnings of the company; *or
cash flow A cash flow is a real or virtual movement of money Image:National-Debt-Gillray.jpeg, In a 1786 James Gillray caricature, the plentiful money bags handed to King George III are contrasted with the beggar whose legs and arms were amputated, in ...
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 is the widely accepted conjecture that there is greater benefit to receiving a sum of money Money is any item or verifiable record that is generally accepted as payment for goods and services and repayment of debts, ...
) 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 h ...
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 h ...
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 Equity may refer to: Finance, accounting and ownership *Equity (finance), ownership of assets that have liabilities attached to them ** Stock, eq ...
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 ratioThe 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: \mbox = \frac The curre ...
(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 famous 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 ...
suggest that neither fundamental analysis nor
technical analysis In finance, technical analysis is an analysis methodology for forecasting the direction of prices through the study of past market data, primarily price and volume. Behavioral economics and Quantitative analysis (finance), quantitative analysis us ...

technical analysis
is useful in outperforming the markets.


See also

*
Stock valuationIn 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 fro ...
* Lists of valuation topics *
Security analysis Security analysis is the analysis of tradeable financial instruments Finance is the study of financial institutions, financial markets and how they operate within the financial system. It is concerned with the creation and management of mone ...
* Piotroski F-score *
Stock selection criterion In financial markets, stock valuation is the method of calculating theoretical values of companies and their share capital, stocks. The main use of these methods is to predict future market prices, or more generally, potential market prices, and thu ...
*
John Burr Williams#Theory
John Burr Williams#Theory
* Mosaic theory *
Chepakovich valuation model
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 A company, abbreviated as co., is a Legal personality, legal entity representing an association of people, whether Natural person, natural, Legal personality, legal o ...


References


External links


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