Fundamental analysis (FA) is a method of measuring a security's intrinsic value by examining related economic and financial factors. Fundamental analysts study anything that can affect the security's value, from macroeconomic factors such as the state of the economy and industry conditions to microeconomic factors like the effectiveness of the company's management.
The outcome of fundamental analysis is a value (or a range of values) of the stock of the company called its 'intrinsic value' (often called 'price target' in fundamental analysts' parlance). It is based on the premise that in the long run true or fair value of an equity share is equal to its intrinsic value.
The intrinsic value of an asset is the present value of all expected future cash inflows (or earnings) from that asset. In case of an equity share it will be equal to the present value all expected future earnings (in the form of dividend, capital gain etc.) from that share because equity shares have infinite life. The expected earnings from an equity share depend upon a variety of economy wide, industry wide and company specific factors. Therefore fundamental analysis involves in-depth analysis of all possible factors having a bearing on company's profitability and future prospects and hence on share price (theoretical or fair price).
Investors would purchase the stock if intrinsic value is above the current market price
If the intrinsic value of a stock is below the market price the investor would sell the stock because he believes that the stock price is going to fall and come closer to intrinsic value
1.2 Approaches To Fundamental Analysis
Top-Down Approach And Bottom-Up Approach.
Top down approach : with this approach the financial analysts are first involved in making forecasts for the economy, then for the industries and finally for the companies. The industry forecasts are based on the forecasts of the economy. Further a company's forecasts are based on the forecasts of the economy as well as the concerned industry.
An investor who follows the top-down approach starts the analysis with the consideration of the health of the overall economy. By analyzing various macroeconomic factors such as interest rates, inflation, and GDP levels, an investor tries to determine the overall direction of the economy and identifies the industries and sectors of the economy offering the best investment opportunities.
Afterward, the investor assesses specific prospects and potential opportunities within the identified industries and sectors. Finally, they analyze and select individual stocks within the most promising industries.
A person who considers using the top-down analysis approach is interested in taking a wider look at the international economy. Then, they determine and measure huge trends going on in the economies, and select the ones offering the most of the opportunities to grow. Industries falling in those macro trends are assessed, and ultimately, the selection of individual stocks lying in the feasible sectors or industries is made. Key points to remember:
Top-down analysis commences with the consideration of macro trends instead of stocks.
Top-down analysis is based on the analysis of global trends, sector analysis, and finally, stock analysis on an individual level.
Top-down analysis approach is considered in technical analysis for analyzing trends for larger time periods prior to restricting them with shorter time periods.
Bottom up approach: In case of bottom up approach, fundamental analysts forecast the prospects of the companies first, then for the industries and in the last forecast for the economy. Such bottom up forecasting may unknowingly involve inconsistent assumptions. Forecasts of the economy is of no use if it is done after company forecasts because ultimately it is the expected cash inflows from the company's share that will be used in finding out the intrinsic value of a share.
1.3 Who Uses Fundamental Analysis?
Fundamental analysis is used largely by long-term or value investors to identify well-priced stocks and those with favorable prospects. Equity analysts will also use fundamental analysis to generate price targets and recommendations to clients (e.g., buy, hold, or sell). Warren Buffett, one of the world's most renowned value investors, is a promoter of fundamental analysis.
Basically if you are an investor wanting to invest in a business for long term (3-5 years) fundamental analysis is for you. The thought process is over the long term, the stock prices of a fundamentally strong company tend to appreciate, thereby creating wealth for its investors.
There are many such examples in the Indian market. To name a few, one can think of companies such as Infosys Limited, TCS Limited, Page Industries, Eicher Motors, Nestle India, TTK Prestige. Each of these companies have delivered on an average over 20% compounded annual growth return (CAGR) year on year for over 10 years. To give you a perspective, at a 20% CAGR the investor would double his money in roughly about 3.5 years. Higher the CAGR faster is the wealth creation process. Some companies such as Bosch India Limited have delivered close to 30% CAGR. Therefore, you can imagine the magnitude, and the speed at which wealth is created if one would invest in fundamentally strong companies.
1.4 Criticisms Of Fundamental Analysis
The biggest criticisms of fundamental analysis come primarily from two groups: proponents of technical analysis and believers of the efficient market hypothesis.
Technical analysis is the other primary form of security analysis. Put simply, technical analysts base their investments (or, more precisely, their trades) solely on the price and volume movements of stocks. Using charts and other tools, they trade on momentum and ignore the fundamentals.
One of the basic tenets of technical analysis is that the market discounts everything. All news about a company is already priced into the stock. Therefore, the stock's price movements give more insight than the underlying fundamentals of the business itself.
Efficient Market Hypothesis (EMH)
Followers of the efficient market hypothesis (EMH), however, are usually in disagreement with both fundamental and technical analysts. The efficient market hypothesis contends that it is essentially impossible to beat the market through either fundamental or technical analysis. Since the market efficiently prices all stocks on an ongoing basis, any opportunities for excess returns are almost immediately whittled away by the market's many participants, making it impossible for anyone to meaningfully outperform the market over the long term.
Weak form EMH
The weak form EMH stipulates that current asset prices reflect past price and volume information. The information contained in the past sequence of prices of a security is fully reflected in the current market price of that security. The weak form of the EMH implies that investors should not be able to outperform the market using something that "everybody else knows". Yet, many financial researchers study past stock price series and trading volume (using a technique called technical analysis) data in an attempt to generate profits.
Semi-strong form EMH
The semi-strong form of the EMH states that all publicly available information is similarly already incorporated into asset prices. In other words, all publicly available information is fully reflected in a security's current market price. Public information here includes not only past prices but also data reported in a company's financial statements, its announcements, economic factors and others. It also implies that no one should be able to outperform the market using something that "everybody else knows". The semi-strong form of the EMH thus indicates that a company's financial statements are of no help in forecasting future price movements and securing high investment returns in the long-term.
Strong form EMH
The strong form of the EMH stipulates that private information or insider information too is quickly incorporated in market prices and therefore cannot be used to reap abnormal trading profits. Thus, all information, whether public or private, is fully reflected in a security's current market price. This means no long-term gains are possible, even for the management of a company, with access to insider information. They are not able to take the advantage to profit from information such as a takeover decision which may have been made a few minutes ago. The rationale to support this is that the market anticipates in an unbiased manner, future developments and therefore information has been incorporated and evaluated into market price in a much more objective and informative way than company insiders can take advantage of.