Fundamental analysis, in accounting and finance, is the analysis of a business's financial statements ; 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 and technical. 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. 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, random walk hypothesis, capital asset pricing model, Fed model Theory of Equity Valuation, 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.
Investors may also use fundamental analysis within different portfolio management 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.
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, interest rates, exchange rates, productivity, 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 and others can be considered either "fundamental" or "technical" based on perception of their validity. Determined growth rates and risk levels are used in various valuation models. The foremost is the discounted cash flow model, which calculates the present value of the future:
dividends received by the investor, along with the eventual sale price;
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. The simple model commonly used is the P/E ratio. Implicit in this model of a perpetual annuity is that the inverse, or the E/P rate, is the discount rate appropriate to the risk of the business. This model does not incorporate earnings growth. 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.
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
Economists such as Burton Malkiel suggest that neither fundamental analysis nor technical analysis is useful in outperforming the markets. This is especially true of low liquidity markets or securities.
