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Fundamental Analysis

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.

Group Selection

If the prognosis is for an expanding economy, then certain groups are likely to benefit more than

others. An investor can narrow the field to those groups that are best suited to benefit from the current

or future economic environment. If most companies are expected to benefit from an expansion, then

risk in equities would be relatively low and an aggressive growth-oriented strategy might be advisable.

A growth strategy might involve the purchase of technology, biotech, semiconductor and cyclical

stocks. If the economy is forecast to contract, an investor may opt for a more conservative strategy

and seek out stable income-oriented companies. A defensive strategy might involve the purchase of

consumer staples, utilities and energy-related stocks.

To assess a industry group's potential, an investor would want to consider the overall growth rate,

market size, and importance to the economy. While the individual company is still important, its

industry group is likely to exert just as much, or more, influence on the stock price. When stocks

move, they usually move as groups; there are very few lone guns out there. Many times it is more

important to be in the right industry than in the right stock! The chart below shows that relative

performance of 5 sectors over a 7-month time frame. As the chart illustrates, being in the right sector

can make all the difference.

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Fundamental Analysis 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 ...
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