Fundamental analysis of a business involves analyzing its financial statements and health, its management and competitive advantages, and its competitors andmarkets. When applied to futures and forex, it focuses on the overall state of the economy, interest rates, production, earnings, and management. When analyzing a stock, futures contract, or currency using fundamental analysis there are two basic approaches one can use; bottom up analysis and top down analysis. The term is used to distinguish such analysis from other types of investment analysis, such as quantitative analysis and technical analysis.
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,
- to calculate its credit risk.
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Use by different portfolio styles
Investors may use fundamental analysis within different portfolio management styles.
- Buy and hold investors believe that latching onto 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 probability of wipe-out.
- Managers may use fundamental analysis to correctly value ‘good’ and ‘bad’ companies. Eventually ‘bad’ companies’ stock goes up and down, creating opportunities for profits.
- Managers may also consider the economic cycle in determining whether conditions are ‘right’ to buy fundamentally suitable companies.
- Contrarian investors distinguish “in the short run, the market is a voting machine, not a weighing machine”. Fundamental analysis allows you to make your own decision on value, and ignore the market.
- Value investors restrict their attention to under-valued companies, believing that ‘it’s hard to fall out of a ditch’. The value comes from fundamental analysis.
- Managers may use fundamental analysis to determine future growth rates for buying high priced growth stocks.
- Managers may also include fundamental factors along with technical factors into computer models (quantitative analysis).
Top-down and bottom-up
Investors can use either a top-down or bottom-up approach.
- The top-down investor starts his analysis with global economics, including both international and national economic indicators, such as GDP growth rates, inflation, interest rates, exchange rates, productivity, and energy prices. He narrows his search down 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 he narrows his search to the best business in that area.
- The bottom-up investor starts with specific businesses, regardless of their industry/region.
The analysis of a business’ health starts with financial statement analysis that includes 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 your perception of their validity.
The 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
- dividends received by the investor, along with the eventual sale price. (Gordon model)
- earnings of the company, or
- cash flows of the company.
The amount of debt is also a major consideration in determining a company’s 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 Price/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 (that is not built into the model).
Growth estimates are incorporated into the PEG ratio, but the math does not hold up to analysis. Its validity depends on the length of time you think 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 year 2000, with the power of computers to crunch vast quantities of data, a new career has been invented. At some funds (called Quant Funds) the manager’s decisions have been replaced by proprietary mathematical models.