What is Fundamental Analysis?
Fundamental analysis is the examination of the underlying forces that affect the well being of the economy, industry groups, and companies. As with most analysis, the goal is to derive a forecast and profit from future price movements. At the company level, fundamental analysis may involve examination of financial data, management, business concept and competition. At the industry level, there might be an examination of supply and demand forces for the products offered. For the national economy, fundamental analysis might focus on economic data to assess the present and future growth of the economy. To forecast future stock prices, fundamental analysis combines economic, industry, and company analysis to derive a stock's current fair value and forecast future value. If fair value is not equal to the current stock price, fundamental analysts believe that the stock is either over or under valued and the market price will ultimately gravitate towards fair value. Fundamentalists do not heed the advice of the random walkers and believe that markets are weak-form efficient. By believing that prices do not accurately reflect all available information, fundamental analysts look to capitalize on perceived price discrepancies.
General Steps to Fundamental Evaluation
Even though there is no one clear-cut method, a breakdown is presented
below in the order an investor might proceed. This method employs a
top-down approach that starts with the overall economy and then works
down from industry groups to specific companies. As part of the analysis
process, it is important to remember that all information is relative.
Industry groups are compared against other industry groups and companies
against other companies. Usually, companies are compared with others in
the same group. For example, a telecom operator (Verizon) would be
compared to another telecom operator (SBC Corp), not to an oil company
(ChevronTexaco).
Economic Forecast
First and foremost in a top-down approach would be an overall
evaluation of the general economy. The economy is like the tide and the
various industry groups and individual companies are like boats. When
the economy expands, most industry groups and companies benefit and
grow. When the economy declines, most sectors and companies usually
suffer. Many economists link economic expansion and contraction to the
level of interest rates. Interest rates are seen as a leading indicator
for the stock market as well. Below is a chart of the S&P 500 and
the yield on the 10-year note over the last 30 years. Although not
exact, a correlation between stock prices and interest rates can be
seen. Once a scenario for the overall economy has been developed, an
investor can break down the economy into its various industry groups.
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