Venkata Reddy.BAssistant professor,Department of ManagementAbhinav Hi-Tech college of Engineering.Email-Id: email@example.comFUNDAMENTAL ANALYSISINTRODUCTION:Fundamental analysis is the cornerstone of investing. In fact, some would say that you arent reallyinvesting if you arent performing fundamental analysis. Because the subject is so broad, however, itstough to know where to start. There are an endless number of investment strategies that are very differentfrom each other, yet almost all use the fundamentals.The goal of this article is to provide a foundation for understanding fundamental analysis. Its gearedprimarily at new investors who dont know a balance sheet from an income statement. While “you maynot be a stock-picker extraordinaire" by the end of this article.The biggest part of fundamental analysis involves delving into the financial statements. Also known asquantitative analysis, this involves looking at revenue, expenses, assets, liabilities and all the otherfinancial aspects of a company. Fundamental analysts look at this information to gain insight on acompanys future performance.OBJECTIVE OF FUNDAMENTAL ANALYSIS:When the objective of the analysis is to determine what stock to buy and at what price, there are two basicmethodologies 1. Fundamental analysis maintains that markets may misprice a security in the short run but that the "correct" price will eventually be reached. Profits can be made by purchasing the mispriced security and then waiting for the market to recognize its "mistake" and reprise the security. 2. Technical analysis maintains that all information is reflected already in the stock price. Trends are your friend and sentiment changes predate and predict trend changes. Investors emotional responses to price movements lead to recognizable price chart patterns. Technical analysis does not care what the value of a stock is. 3. Investors can use any or all of these different but somewhat complementary methods for stock picking. For example many fundamental investors use technical’s for deciding entry and exit points. Many technical investors use fundamentals to limit their universe of possible stock to good companies.
4. The choice of stock analysis is determined by the investors belief in the different paradigms for "how the stock market works". 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.TYPES OF FUNDAMENTAL ANALYSIS:Fundamental analysis includes: 1. Economic analysis 2. Industry analysis 3. Company analysisOn the basis of these three analyses the intrinsic value of the shares are determined. This is considered asthe true value of the share. If the intrinsic value is higher than the market price it is recommended to buythe share. If it is equal to market price hold the share and if it is less than the market price sell the shares.TOOLS OF FUNDAMENTAL ANALYSIS:Fundamental analysis is a method used to determine the value of a stock by analyzing the financial datathat is fundamental to the company. That means that fundamental analysis takes into consideration onlythose variables that are directly related to the company itself, such as its earnings, its dividends, and itssales. Fundamental analysis does not look at the overall state of the market nor does it include behavioralvariables in its methodology. It focuses exclusively on the companys business in order to determinewhether or not the stock should be bought or sold.EarningsIt is often said that earnings are the "bottom line" when it comes to valuing a companys stock, and indeedfundamental analysis places much emphasis upon a companys earnings. Simply put, earnings are howmuch profit (or loss) a company has made after subtracting expenses. During a specific period of time, allpublic companies are required to report their earnings on a quarterly basis through a 10-Q Report.Earnings are important to investors because they give an indication of the companys expected dividendsand its potential for growth and capital appreciation. That does not necessarily mean, however, that low ornegative earnings always indicate a bad stock; for example, many young companies report negativeearnings as they attempt to grow quickly enough to capture a new market, at which point theyll be evenmore profitable than they otherwise might have been.Earnings Per Share:Comparing total net earnings for various companies is usually not a good idea, since net earningsnumbers dont take into account how many shares of stock are outstanding (in other words, they dont takeinto account how many owners you have to divide the earnings among). In order to make earningscomparisons more useful across companies, fundamental analysts instead look at a companys earningsper share (EPS). EPS is calculated by taking a companys net earnings and dividing by the number ofoutstanding shares of stock the company has. For example, if a company reports $10 million in net
earnings for the previous year and has 5 million shares of stock outstanding, then that company has anEPS of $2 per share. EPS can be calculated for the previous year ("trailing EPS"), for the current year("current EPS"), or for the coming year ("forward EPS").P/E RatioEPS is a great way to compare earnings across companies, but it doesnt tell you anything about how themarket values the stock. Thats why fundamental analysts use the price-to-earnings ratio, more commonlyknown as the P/E ratio, to figure out how much the market is willing to pay for a companys earnings.You can calculate a stocks P/E ratio by taking its price per share and dividing by its EPS. For instance, ifa stock is priced at $50 per share and it has an EPS of $5 per share, then it has a P/E ratio of 10. (Orequivalently, you could calculate the P/E ratio by dividing the companys total market cap by thecompanys total earnings; this would result in the same number.) P/E can be calculated for the previousyear ("trailing P/E"), for the current year ("current P/E"), or for the coming year ("forward P/E"). Thehigher the P/E, the more the market is willing to pay for each dollar of annual earnings.Dividend YieldThe dividend yield measures what percentage return a company pays out to its shareholders in the formof dividends. It is calculated by taking the amount of dividends paid per share over the course of a yearand dividing by the stocks price. For Example, if a stock pays out $2 in dividends over the course of ayear and trades at $40, then it has a dividend yield of 5%. Mature, well-established companies tend tohave higher dividend yields, while young, growth-oriented companies tend to have lower ones, andmost small growing companies dont have a dividend yield at all because they dont pay out dividends.Dividend Payout RatioThe dividend payout ratio shows what percentage of a companys earnings it is paying out to investors inthe form of dividends. It is calculated by taking the companys annual dividends per share and dividing byits annual earnings per share (EPS). So, if a company pays out $1 per share annually in dividends and ithas an EPS of $2 for the year, then that company has a dividend payout ratio of 50%; in other words, thecompany paid out 50% of its earnings in dividends. Companies that distribute dividends typically useabout 25% to 50% of their earnings for dividend payments. The higher the payout ratio, the lessconfidence the company has that it wouldve been able to find better uses for the money it earned. This isnot necessarily either good or bad; companies that are still growing will tend to have lower dividendpayout ratios than very large companies, because they are more likely to have other productive uses forthe earnings.Book ValueThe book value of a company is the companys net worth, as measured by its total assets minus its totalliabilities. This is how much the company would have left over in assets if it went out of businessimmediately. Since companies are usually expected to grow and generate more profits in the future, mostcompanies end up being worth far more in the marketplace than their book value would suggest. For thisreason, book value is of more interest to value investors than growth investors. In order to compare book
values across companies, you should use book value per share, which is simply the companys lastquarterly book value divided by the number of shares of stock it has outstanding.Price / BookA companys price-to-book ratio (P/B ratio) is determined by taking the companys per share stock priceand dividing by the companys book value per share. For instance, if a company currently trades at $100and has a book value per share of $5, then that company has a P/B ratio of 20. The higher the ratio, thehigher the premium the market is willing to pay for the company above its hard assets. Price-to-book ratiois of more interest to value investors than growth investors.Price / Sales RatioAs with earnings and book value, you can find out how much the market is valuing a company bycomparing the companys price to its annual sales. This measure is known as the price-to-sales ratio (P/Sor PSR). You can calculate the P/S by taking the stocks current price and dividing by the companys totalsales per share for the past year (or equivalently, by dividing the entire companys market cap by its totalsales). That means that a company whose stock trades at $1 per share and which had $2 per share in saleslast year will have a P/S of 0.5. Low P/S ratios (below one) are usually thought to be the better investmentsince their sales are priced cheaply. However, P/S, like P/E ratios and P/B ratios, are numbers that aresubject to much interpretation and debate. Sales obviously dont reveal the whole picture: a companycould be selling dollar bills for 90 cents each, and have huge sales but be terribly unprofitable. Because ofthe limitations, P/S ratios are usually used only for unprofitable companies, since such companies donthave a P/E ratio.Return on Equity (ROE)Return on equity (ROE) shows you how much profit a company generates in comparison to its bookvalue. The ratio is calculated by taking a companys after-tax income (after preferred stock dividends butbefore common stock dividends) and dividing by its book value (which is equal to its assets minus itsliabilities). It is used as a general indication of the companys efficiency; in other words, how much profitit is able to generate given the resources provided by its stockholders. Investors usually look forcompanies with ROEs that are high and growingSTRENGTHS AND WEAKNESS OF FUNDAMENTAL ANALYSISStrengths of Fundamental Analysis:Long-term TrendsFundamental analysis is good for long-term investments based on long-term trends, very long-term. Theability to identify and predict long-term economic, demographic, technological or consumer trends canbenefit patient investors who pick the right industry groups or companies.
Value SpottingSound fundamental analysis will help identify companies that represent a good value. Some of the mostlegendary investors think long-term and value. Graham and Dodd, Warren Buffett and John Neff are seenas the champions of value investing. Fundamental analysis can help uncover companies with valuableassets, a strong balance sheet, stable earnings, and staying power.Business AcumenOne of the most obvious, but less tangible, rewards of fundamental analysis is the development of athorough understanding of the business. After such painstaking research and analysis, an investor will befamiliar with the key revenue and profit drivers behind a company. Earnings expectations can be potentdrivers of equity prices. Even some technicians will agree to that. A good understanding can helpinvestors avoid companies that are prone to shortfalls and identify those that continue to deliver. Inaddition to understanding the business, fundamental analysis allows investors to develop anunderstanding of the key value drivers and companies within an industry. A stocks price is heavilyinfluenced by its industry group. By studying these groups, investors can better position themselves toidentify opportunities that are high-risk (tech), low-risk (utilities), growth oriented (computer), valuedriven (oil), non-cyclical (consumer staples), cyclical (transportation) or income-oriented (high yield).Knowing Whos WhoStocks move as a group. By understanding a companys business, investors can better position themselvesto categorize stocks within their relevant industry group. Business can change rapidly and with it therevenue mix of a company. This happened too many of the pure Internet retailers, which were not reallyInternet companies, but plain retailers. Knowing a companys business and being able to place it in agroup can make huge difference inrelative valuations.Weaknesses of Fundamental AnalysisTime ConstraintsFundamental analysis may offer excellent insights, but it can be extraordinarily time-consuming. Time-consuming models often produce valuations that are contradictory to the current price prevailing on WallStreet. When this happens, the analyst basically claims that the whole street has got it wrong. This is notto say that there are not misunderstood companies out there, but it is quite brash to imply that the marketprice, and hence Wall Street, is wrong.Industry/Company SpecificValuation techniques vary depending on the industry group and specifics of each company. For thisreason, a different technique and model is required for different industries and different companies. Thiscan get quite time-consuming, which can limit the amount of research that can be performed. Asubscription-based model may work great for an Internet Service Provider (ISP), but is not likely to be thebest model to value an oil company.
SubjectivityFair value is based on assumptions. Any changes to growth or multiplier assumptions can greatly alter theultimate valuation. Fundamental analysts are generally aware of this and use sensitivity analysis topresent a base-case valuation, a best-case valuation and a worst-case valuation. However, even on aworst-case valuation, most models are almost always bullish, the only question is how much so.Analyst BiasThe majority of the information that goes into the analysis comes from the company itself. Companiesemploy investor relations managers specifically to handle the analyst community and release information.As Mark Twain said, "there are lies, damn lies, and statistics." When it comes to massaging the data orspinning the announcement, CFOs and investor relations managers are professionals. Only buy-sideanalysts tend to venture past the company statistics. Buy-side analysts work for mutual funds and moneymanagers.CONCLUSION:Whenever you’re thinking of investing in a company it is vital that you understand what it does, itsmarket and the industry in which it operates. You should never blindly invest in a company. One of themost important areas for any investor to look at when researching a company is the financial statements.It is essential to understand the purpose of each part of these statements and how to interpret them.Reference:http://www.investopedia.com/university/fundamentalanalysis/fundanalysis.