Fundamental analysis is all about analyzing the current business performance of a company and value it to know the worth. Investors/ analysts examine several parameters to attain the true intrinsic value of a firm which includes analyzing competitors, company risks, target market for the firm, financials, current performance etc. The fundamental analysis also considers the macroeconomic factors like overall state of the economy, its growth, demand, supply and factors including interest rates, production, earnings growth, employment numbers, GDP growth and the list goes on. It usually depends on the Analyst/investor/individual on choosing the parameters or approaches to perform the fundamental analysis of a firm.
There are two basic approaches that are used in the fundamental analysis, bottom up analysis and top down analysis. Fundamental analysis involves analysis of historical and present data to make financial forecasts for the future years. There are various tools for valuation like efficient-market hypothesis, random walk hypothesis, capital asset pricing model, Fed model Theory of Equity Valuation, market-based valuation, and behavioral finance.
Top-down approach starts with analysis entailing Economic study involving global economics, including both international and national economic indicators. These may include factors like GDP growth rates, inflation, interest rates, energy prices of crude and natural gas, foreign exchange fluctuations etc. Then the investors go for regional/ industry analysis of total sales, price levels, the effects of competing products, foreign competition, and entry or exit from the industry. After analyzing the industry, investors/ analysts go for company analysis.
The bottom-up approach by few investors and analysts begins with company analysis, which may sometimes be irrelevant to the industry/region, and is a reverse of the top-down approach.
Fundamental analysis of three important factors:
- Economic analysis: For a top-down approach the overall performance of the economy like economy expansion, industry performance etc. is understood. However, contraction of economy leads to a downturn for many sectors and companies, and many economists relate economic expansion / contraction to interest rates, which becomes important for stock market as well.
- Industry analysis: Companies positioned in a growing industry can grow faster as compared to the firms placed in saturated industries. Again, there is always an exception. Growth strategy could be buying stocks placed in target industry like technology, biotech, semiconductor and even going for cyclical stocks depending on the phase. If the industry is matured, conservative strategy investors look for stable income-oriented companies. However, risk averse investors opt for sectors like consumer staples, utilities, and energy-related stocks. One then needs to evaluate the overall growth rate, market size, and study economy changes to attain a view on target industry.
- Company analysis: It involves the analysis of the quality to manage for long term investments. Investors might look at management to assess their capabilities, strengths and weaknesses. Sometimes, an inexperienced or bad management can drown the best laid plans in the dynamic industries. The next step is to analyze the financial health of the company and then to value the stock.
Attaining Intrinsic value or the fair value is the major parameter in fundamental analysis. Generally, if the intrinsic value is higher than the market price, than 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 investor could sell the shares. But if the overall stock market performance is gloomy than buying/selling stocks based on intrinsic value needs to be done cautiously.
Basic fundamental analysis for stock recommendations include:
- Analyzing growth rates, margins and ratios like price to earnings, price to book value etc.
- Looking at historical financial parameters
- Looking at Dividends/shareholder’s return
- Assessing Factors affecting the earnings of the company
- Assessing the cash flows of the company, to find the liquidity of the company
- Looking at Leverage, which is the amount of debt a company possesses and is also a major consideration in determining its financial condition of the company. It can be quickly assessed using the debt-to-equity ratio and the current ratio (current assets/current liabilities).
- Accessing the P/E ratio (price-to-earnings ratio) to conduct a company stock valuation and predict its probable price evolution
- Looking at business performance
- Looking at Industry cycle, whether the company is in matured industry or is a startup
- Reviewing Seasonal cycle of the company and its performance during the time
- Looking at top management, how they make business plans, take internal business decisions and/or calculate its credit risk.
- Making the projection to find the internal value of the stock taking everything into consideration
The Income available from dividends remains attractive for many investors.
We take a look at the best yields on the market and assess what they say about a company’s prospect.
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