Fundamental Analysis of Stocks

Definition of Fundamental Analysis

Fundamental analysis of stocks is defined as the practice of examining the fundamentals of an organization in order to determine if a business has turned out to be a good investment. Fundamental analysis aims are answering questions related to the business finance and capital investment, such as “what are the probabilities that this business investment is going to fail or become bankrupt” and “how sure can a portfolio manager be that the stock continues to pay dividends?” In other words, fundamental analysis involves detailed study in regards to financial statements like the balance sheet. It is considered as a complete contrast to technical analysis of stocks.

Fundamental Analysis of Stocks

Fundamental analysis of stocks deals with the analysis of the financial, economic, as well as other quantitative and qualitative elements associated with a security with the sole intention of determining its intrinsic value. Even though this technique is employed for evaluating the value of a firm’s stock, it can additionally be used for any form of security, such as currency and bonds. Also known as quantitative analysis, fundamental analysis involves digging into a corporation’s financial statements, including profit and loss accounts, balance sheet, etc, in order to analyze different types of financial indicators like earnings, revenues, expenses, assets and liabilities. This type of study is typically conducted by analysts, brokers and investors.

Stages of Fundamental Analysis

The investor while buying stock has the primary purpose of gain. If he invests for a short period of time it is speculative but when he holds it for a fairly long period of time the anticipation is that he would receive some return on his investment. Fundamental analysis of stocks is a method of finding out the future price of a stock or share, which an investor wishes to buy. The fundamental analysis of stocks involves;

1. Company Analysis

Company analysis is a study of the variables that influence the future of a firm both qualitatively and quantitatively. It is a method of assessing the competitive position of a firm earning and profitability, the efficiency with which it operates and its financial position with respect to the earning to its shareholders. The fundamental nature of this analysis is that each share of a company has an intrinsic value, which is dependent on the company’s financial performance, quality of management and record of its earnings and dividend. They believe that the market price of share in a period of time will move towards its intrinsic value. If the market price of a share is lower than the intrinsic value, as evaluated by the fundamental analysis of stocks, then the share is supposed to be undervalued and it should be purchased but if the current market price shows that it is more than intrinsic value then according to the theory the share should be sold. This basic approach is analyzed through the financial statements of an organization. The basic financial statements, which are required as tools of the fundamental analyst, are the income statement, the balance sheet, and the statement of changes in financial position. These statements are useful for investors, creditors as well as internal management of a firm and on the basis these statements the future course of action may be taken by the investors of the firm. While evaluating a company, its statement must be carefully judged to find out that they are:

  1. Correct,
  2. Complete,
  3. Consistent and
  4. Comparable.

2. Industry Analysis

The industry has been defined as homogeneous groups of people doing a similar kind of activity or similar work. In India, the broad classification of industry is made according to stock exchange list, which is published. This gives a distinct classification to industry to industry in different forms such as: Engineering, Banking and Insurance, Textiles, Cement, Steel Mills and Alloys, Chemicals and Pharmaceuticals, Retail, Sugar, Information Technology, Automobiles and Ancillary, Telecommunications, FMCG and Miscellaneous.

Industry should also be evaluated or analyzed through its life cycle. Industry life cycle may also be studied through the industrial life cycle state. There are generally three stages of an industry. These stages are pioneering stage, expansion stage and stagnation stage.

  1. THE PIONEERING STAGE: The industrial life cycle has a pioneering stage when the new inventions and technological developments take place. During this time the investor will notice great increase in the activity of the firm. Production will rise and in relation to production, there will be a great demand for the product. At this stage, the profits are also very high as the technology is new. Taking a look at the profit many new firms enter into the same field till the market becomes competitive. The market competitive pressures keep on increasing with the entry of new-firms and the prices keep on declining and then ultimately profits fall. At this stage all firms compete with each other and only a few efficient firms are left to run the business and most of the other firms are wiped out in the pioneering stage itself.
  2. THE EXPANSION STAGE: The efficient firms, which have been in the market now, find that it is time to stabilize them. Although competition is there, the, number of firms have gone down during pioneering stage itself and there are a large number of firms left to run the business in the industry. This is the time when each one has to show competitive strength and superiority. The investor will find that this is the best time to make an investment. At the pioneering stage it was difficult to find out which of the firm to invest in, but having waited for the stability period there has been a dynamic selection process and a few of the large number of firms are left in the industry. This is the period of security and safety and this is also called period of maturity for the firm. This stage lasts from five years to fifty years of a firm depending on the potential and productivity and also the capability to meet the change in competition and rapid change in customer habit.
  3. STAGNATION STAGE: During the stagnation stage the investor will find that although there is increase in sales of an organization, this is not in relation to the profits earned by the company. Profits are also there but the growth in the firm is lower than it was in the expansion stage. The industry finds that it is at a loss of power and cannot expand. During this stage most of the firms who have realized the competitive nature of the industry, begin to change their course of action and start on a new venture . Investor should make a continuous evaluation of their investments. In firms in which investors have received profits for large number of years and have reached stagnation stage,  they should sell off their investment in those firms and find better avenues in those firms where the expansion stage has set in, many be in another industry.

3. Economic Analysis

Investors are concerned with those forces in the economy, which affect the performance of organizations in which they wish to participate, through purchase of stock. A study of the economic forces would give an idea about future corporate earnings and the payment of dividends and interest to investors. Some of the broad forces within which the factors of investment operate are:

  1. POPULATION: Population gives an idea of the kind of labor force in a country. In some countries the population growth has slowed down whereas in India and some other third world countries there has been a population explosion. Population explosion will give demand for more industries like hotels, residences, service industries like health, consumer demand like refrigerators and cars. Likewise, investors should prefer to invest in industries, which have a large amount of labor force because in the future such industries will bring better rates of return.
  2. RESEARCH AND TECHNOLOGICAL DEVELOPMENTS: The economic forces relating to investments would be depending on the amount of resources spent by the government on the particular technological development affecting the future. Broadly the investor should invest in those industries which are getting a large amount of share in the funds of the development of the country. For example, in India in the present context automobile industries and spaces technology are receiving a greater attention. These may be areas, which the investor may consider for investments.
  3. CAPITAL FORMATION: Another consideration of the investor should be the kind of investment that a company makes in capital goods and the capital it invests in modernization and replacement of assets. A particular industry or a particular company which an investor would like to invest can also be viewed at with the help of the economic indicators such as the place, value and property position of the industry, group to which it belongs and the year-to-year returns through corporate profits.
  4. NATURAL RESOURCES AND RAW MATERIALS: The natural resources are to a large extent are responsible for a country’s economic development and overall improvement in the condition of corporate growth. In India, technological discoveries recycling of materials, nuclear and solar energy and new synthetics should give the investor an opportunity to invest in untapped or recently tapped resources which would also produce higher investment opportunity.

Advantages and Disadvantages of Fundamental Analysis

Advantages of Fundamental Analysis

Fundamental analysis of stocks is beneficial for:

  • Identification of the intrinsic value of a security
  • Identification of long-term investment opportunities because it includes real time data
  • Employing fundamental analysis for predicting future prices is based on the principle of “one thing causes another”, and hence tries to recognize the causing factors. Therefore, with this concept, the approach of fundamental analysis is said to be intuitively appealing.
  • Because relationships are examined by mathematical and statistical techniques, fundamental analysis is objective. Those relationships that fail are removed, whereas those that successfully pass are considered to be credible. Further, there is no room for personal opinion or bias. Many traders greatly depend on objectivity and hold little confidence in their ability to predict prices on pure discretion basis. Furthermore, future traders do not find it difficult to attempt to predict variables through the process of fundamental analysis. Organizations attempt to predict sales, government agencies attempt to predict unemployment and meteorology specialists attempt to predict the weather conditions. With all of these sectors trying to harness the power of fundamental analysis, one advantage of using fundamental analysis is the enhancement and refinement in the pool of techniques available for fundamental analysis. For instance, if an effective technique is developed for predicting the weather, it can be easily applied to future prices and help in obtaining satisfactory outcomes. And this is just how a specific form of fundamental analysis termed as the Chaos Theory, entered the realm of the future traders.

Disadvantages of Fundamental Analysis

However, fundamental analysis of stocks is equipped with the following drawbacks:

  • It can be used only for analyzing long-term investments.
  • Too many economic indicators together with widened macroeconomic data tends to produce confusion for new investors.
  • Similar set of information regarding macroeconomic indicators may impose different effects on the same currencies at varied times.
  • A substantial amount of human labor is needed for fundamental analysis of stocks, including time and energy. Additionally, recent techniques have gotten increasingly complex and few individuals have turned towards obtaining help from trained economists who can properly apply the available technology. For example, large banks usually hire teams of economists for devising their in-house prediction models.
  • Fundamental analysis of stocks entirely counts on a significant quantity of data to analyze the importance of variables. Such data are most often difficult to acquire and, most importantly, are rarely available without extra charge. Data are also contaminated with notable errors that must first be detected and repaired.
  • It is often not very easy, even though data, time and energy are acquirable, to define a relationship which is very robust and which allows for satisfactory price prediction. In part, this may be due to the fact that numerous variables are connected together, each having a diverse effect on the other, that it becomes difficult to realize causal relationships. A lot of time, energy and money could be spent looking for causal relationships, but never land up finding one.

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