Fundamental analysis

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.

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

1. 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 or selling the wrongly priced security and then waiting for the market to
recognize its "mistake" and reprice the security.
2. 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.[3]

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, market-based valuation, and
behavioral finance.

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

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".[4] 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

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" (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:
 dividends 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) 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 is more meaningful than the P/E ratio. The PEG ratio 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 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 ratio (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 suggest that neither fundamental analysis nor technical analysis is
useful in outperforming the markets.[5]

See also
Stock valuation
Lists of valuation topics
Security analysis
Piotroski F-score
Stock selection criterion
John Burr Williams#Theory
Mosaic theory
Chepakovich valuation model
Financial forecast

References
1. "Technical Analysis vs. Fundamental Analysis" (https://web.archive.org/web/201503120908
14/http://www.mta.org/eweb/dynamicpage.aspx?webcode=what-is-technical-analysis).
Market Technicians Association. Archived from the original (http://www.mta.org/eweb/dynami
cpage.aspx?webcode=what-is-technical-analysis) on 12 March 2015. Retrieved 6 March
2015.
 2. "An Introduction to Fundamental Analysis and the US Economy" (https://web.archive.org/we
b/20090721191203/http://www.informedtrades.com/13036-introduction-fundamental-analysi
s-us-economy.html#post13168). InformedTrades.com. 2008-02-14. Archived from the
original (http://www.informedtrades.com/13036-introduction-fundamental-analysis-us-econo
my.html#post13168) on 2009-07-21. Retrieved 2009-07-27.
3. 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.
4. Graham, Benjamin; Dodd, David (December 10, 2004). Security Analysis. McGraw-Hill.
ISBN 978-0-07-144820-8.
5. "Financial Concepts: Random Walk Theory" (http://www.investopedia.com/university/concep
ts/concepts5.asp). Investopedia.

External links
MIT Financial-Management course notes (http://ocw.mit.edu/courses/sloan-school-of-manag
ement/15-414-financial-management-summer-2003/)
Fundamental Analysis Works (https://ssrn.com/abstract=2479817)

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