We will begin by exploring the concept of intrinsic value and understanding its centrality to fundamental analysis. Then, we will contrast fundamental analysis with the other branch of equity analysis technical analysis. Finally, we will close this article with a description the limitations of fundamental analysis.
Equity analysis seeks to assess whether a company’s shares can be expected to appreciate from their current value. You can only expect the appreciation, if their current price is below what you think it should be, i.e., if they are undervalued. What you ‘think’ the share’s price should actually be is the definition of intrinsic value.
Thus, what equity analysis truly seeks to do is to ascertain the inherent value of a share and compare it with its current market price to determine whether you should buy it or not.
There are different approaches to determining this value – fundamental analysis and technical analysis.
If you are a technical analyst, you will study the historic price chart of a stock. You will look for patterns in it that will help you ascertain its real value. Some of the important patterns used for technical analysis are double top, double bottom, head and shoulder and candle. On the basis of these, technical analysts establish a trading-range.
The upper limit of the range is called resistance. Once the price reaches close to this, you may choose to sell the stock because then on, its price should fall. The lower end of the range is called support.
This is because once the price falls to this level, it is expected to rebound. You should therefore, buy the stock at this level. If the resistance is breached, the stock is expected to appreciate wildly. Similarly, if the support is breached, the stock is expected to go into freefall. Such breaches are called trading-range breaks.
If you are a fundamental analyst, you will first conduct a qualitative analysis, wherein, you will look at things like the company’s quality of management, corporate governance standards, quality of earnings, competitive position etc. Then, based on these, you will project its future earnings. Intrinsic value can also be defined as the value of these future earnings in terms of today’s money. The present value approach/model is used for this calculation. We will discuss it in detail in subsequent sections.
You may also use an approach called the relative value approach for ascertaining the stock’s real value. Herein, you will calculate the inherent value of a company’s shares based on the fundamentals of its competitors. You may first calculate the ratio of the market price of the competitors with a fundamental such as sales, book value or net income.
Then, you may apply this ratio to the fundamental of the concerned company and comment on its value. Like the present value approach, here too you may begin your analysis with an assessment of qualitative factors. This approach too will be discussed in detail in subsequent sections.
This value calculated using one of these methods is then compared to the current price of the company’s stock. It helps ascertain if the shares are undervalued or overvalued. It is bought if it is overvalued and left alone otherwise. An illustration of this value calculation process is given below.
While fundamental and technical analyses have both yielded impressive returns to their users, they are completely distinct from each other. Following are the key distinguishing factors:
As mentioned earlier, fundamental analysis seeks to explore a company’s ‘fundamentals’ to comment about its value, i.e. it evaluates crucial performance related criteria such as management quality, corporate governance, sales, profit, future plans, condition of assets and policies related to liabilities managements to predict the future performance of the company.
Technical analysis does not bother at all with the accounts of a company.
It looks at patterns in the price chart of the company for bullish (optimistic) and bearish (pessimistic) trends. It combines this with a statistical analysis of historical price data, such as 52-week average, moving average and price momentum, to determine the future price of a stock. These tools are together referred to as relative strength indicators.
In case of fundamental analysis, the analyst has faith in his ability to predict how the company’s financial statements will look in future periods.
For this, he may rely on his assessment of present factors or even past trends related to the company’s operations.
When performing fundamental analysis, you may choose to project performance as far in the future you like—months or even years. Thus, fundamental analysis is predominantly used for long term investments.
However, sometimes, an event, such as a favorable court ruling or getting a large sales order takes place. This changes the company’s earnings potential in the short run, without impacting it much in the long run. You may invest in a stock for a short period of days or weeks, in anticipation of such an event. This is called trading. Fundamental analysis allows you to both trade and invest.
Technical analysis, on the other hand is predominantly used for trading. In the long term, fundamental factors change drastically. For this reason, historical data become completely irrelevant.
For example, if a company sets up new production facilities, its future earnings potential may increase drastically over time. In such a case, the price range for its stock would change completely as well. Investment decisions based on past data will therefore, not bear fruits.
Technical analysis is based on the assumption that historical patterns repeat themselves over time. Thus, if these patterns can be studied closely, comments can be made regarding future prices. This analysis is supported by a study of market volumes data and relative strength indicators.
Fundamental analysis is an extensive approach to equity analysis. It involves the study of a lot of material. The starting point of fundamental analysis is always the annual report and quarterly reports of the company. An annual report is a document that contains extensive information about the company’s performance during a given year.
It includes the three main financial statements, along with detailed notes; a report on corporate governance, management discussion and analysis (MD&A) and other information about the company’s activities during the year. A description of its future objectives is also included. Quarterly reports are produced more frequently.
They only contain the financial statements of the company. Also, annual reports are audited externally to ensure that the information in them is accurate. This is not true of quarterly reports. Once done with these reports, you must also consider other sources, such as reports published by brokerages and industry bodies, news pieces about the company and its industry etc.
Naturally, no such content is required for technical analysis. Technical analysts only require data related to the stock’s historical price and market volumes. Sometimes, they also use complex computer software for statistical analysis of prices.
Historical evidence proves that investors make more money by investing in good companies for the long run compared to making opportunistic, short-term punts. Thus, fundamental analysis promises greater rewards than technical analysis. Even so, it is not free of shortcomings. Let’s look at some of them before we move ahead.
Fundamental analysis is more an art than a science. Although analysts follow a uniform series of steps, the analysis at each step is different, based on the specifics of the company under analysis and the analyst’s philosophy.
In addition to errors and omissions, the pure uncertainty regarding future events also plagues fundamental analysis. One can never provide for events like strikes, thefts and acts of god in the analysis. However, their occurrence can lay to waste the entire analysis.
The number of steps involved and the scrutiny required at each stage makes fundamental analysis a very long and tiresome job. It requires a lot of patience and time.
When conducting fundamental analysis, analysts try to picture the future. This naturally involves the use of many assumptions. They range from the growth rate of sales, to the future capital structure (proportion of debt and equity) of the company. This places the analysis on a weak footing. Miscalculation or omission of a single factor can drastically affect the intrinsic value calculated.
Fundamental analysis-based investing banks on the faith that a stock is undervalued and will appreciate to its true value in due course of time. However, it provides no way of determining how long this course will be. This leads to a blockage of funds for an uncertain length of time.
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