Stock Valuation Technique-Fundamental Analysis

November 24, 2009 Tuesday

Fundamental analysis involves examining the economic, financial, qualitative and quantitative factors in order to identify the intrinsic value of a security. It is also known as quantitative analysis. It involves into analyzing financial statements of the company like profit and loss account and balance sheet. This is very important analysis which decides the future of various investors. For the fundamentalist, the market price of a stock tends to move towards its intrinsic value. If the intrinsic value of a stock is above the current market price, the investor would purchase the stock because he knows that the stock price would rise and move towards its “intrinsic or real value”. If the intrinsic value of a stock was below the market price, the investor would sell the stock because he knows that the stock price is going to fall and come closer to its intrinsic value in the near future.

Fundamental factors

Various fundamental factors can be grouped into two categories such as;

Quantitative factors
Qualitative factors

Quantitative factors

Quantitative factors are capable of being measured or expressed in numerical terms

Qualitative factors

Qualitative factors are related to or based on the quality or character of something, often as opposed to its size or quantity.

Quantitative fundamentals are numeric, measurable characteristics about a business. It helps to measure revenue, profit, and assets

Fundamental analysis tools

Fundamental analysts use different tools in order to find the value of a security. These tools focus on earnings, growth, and value in the market. Only a single number i.e. the result of these cannot be the deciding factor for buying or selling of stocks. They can act only as benchmarks to decide the potential investments. These are the most important tools for fundamental analysis.

Earnings per Share
Price-to-earnings Ratio
Price to sales
Price to book
Dividend payout ratio
Dividend yield
Book Value
Return on equity

In our previous article on Fundamental Analysis we have discussed about all the Tools used in Fundamental Analysis.

Fundamental analysis process

The overall process of using fundamental analysis can be seen in four steps :

Establishing initial investment criteria
Analyzing financial statements and ratio analysis
Stock valuation
Finally deciding whether to buy or not.

Strengths of Fundamental analysis

Following are the major strengths of fundamental analysis;

Long term trends
Value investment
Complete Knowledge
Forecasting companies future

Long term trends

Fundamental analysis is always regarded good for long term investments. They help in identifying long-term economic, demographic, technological or consumer trends which can benefit various investors to pick right industry groups and companies.

Value investment

Good fundamental analysis helps investor in identifying companies that represent a good value. It analysis can help uncover companies with valuable assets, a strong balance sheet, stable earnings, and staying power.

Complete Knowledge

It helps in giving complete knowledge about the company. Since businesses change rapidly and also the revenue mix changes, investors must keep track time to time of these changes to avoid any kind of risk.

Forecasting company’s future

The thorough understanding of a business will help investors in deciding the company’s growth. A good understanding can help investors avoid companies that are prone to shortfalls and identify those that continue to deliver. investors can better position themselves to identify opportunities that are high-risk (tech), low-risk (utilities), growth oriented (computer), value driven (oil), non-cyclical (consumer staples), cyclical (transportation) or income-oriented (high yield).

Drawbacks of Fundamental analysis

Following are the chief strengths of fundamental analysis;

Time constraints
Industry or company specific
Subjectivity

Time constraints

Fundamental analysis may give valuable insights but it is very much time consuming. They usually come up results that are contradictory to the prevailing price in the market. This creates a lot of confusion in the minds of investors.

Industry or company specific

The method of valuation varies from one industry to another, in this case they have to develop industry specific methods. This can get time consuming and limits the amount of research that can be performed.

Subjectivity

Fair value is based on assumptions. The analysts are generally aware of this end use sensitivity analysis to present a base-case valuation, an average-case valuation and a worst-case valuation.

Fundamental analysis can prove very much fruitful if it is approached with caution. If we judge the research with reliability, we can get a god result. Corporate statements and press releases offer good information, but that should be read with a healthy degree of cynicism to separate the facts from the spin. Investors must try and understand the useful information and ignore the hype created by various people who are trying benefit out of it.

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