What is Fundamental Analysis?

The crux of Fun­da­men­tal Analy­sis lies in its attempt to deter­mine the eco­nomic value of a secu­rity (a generic term for stocks and shares)…”

Fun­da­men­tal Analy­sis cov­ers the area of research that stud­ies eco­nom­ics, indus­try and com­pany infor­ma­tion for the pur­pose of mak­ing an informed judge­ment on a stock’s value and its growth poten­tial. The crux of Fun­da­men­tal Analy­sis lies in its attempt to deter­mine the eco­nomic value of a secu­rity (a generic term for stocks and shares).

The Focus of Fun­da­men­tal Analy­sis
Eco­nomic Analy­sis cov­ers the study of the country’s eco­nomic indi­ca­tors such as new orders, money sup­ply, stock price indices, stocks of unfin­ished goods, new busi­ness for­ma­tions, con­sumer price index and unit labour costs. Impor­tant eco­nomic con­sid­er­a­tions would include inter­est rates and infla­tion and its impact on the stock mar­ket, the level of gov­ern­ment debt, the level of cor­po­rate debts, mon­e­tary and fis­cal policy.

Indus­try Analy­sis cov­ers the struc­ture and state of com­pe­ti­tion in the indus­try, nature and prospects of demand for prod­ucts and ser­vices of the indus­try, cost con­di­tions and prof­itabil­ity, tech­nol­ogy and research require­ments, the imme­di­ate and long term out­look for sales and profit.

Com­pany Analy­sis
Com­pany Analy­sis cov­ers man­age­ment analy­sis and finan­cial analy­sis. Man­age­ment analy­sis would con­sider the busi­ness acu­men of the CEO and top man­agers, the past record and per­for­mance of the CEO and the cor­po­rate work ethic. Finan­cial Analy­sis would con­sider rev­enue, costs, earn­ings of the com­pany and the company’s cap­i­tal struc­ture as reflected by its debt to equity ratio. Finan­cial Analy­sis in the form of finan­cial ratio analy­sis com­pares the company’s cur­rent stock price to its earn­ings, div­i­dends, and assets. The­ses finan­cial val­u­a­tion ratios and then com­pared the finan­cial val­u­a­tion of other com­pa­nies in the same indus­try to iden­tify over­val­ued and under­val­ued com­pa­nies in terms of earn­ings, div­i­dends and assets.

The Father of Fun­da­men­tal Analy­sis
A dis­cus­sion of Fun­da­men­tal Analy­sis would be incom­plete with­out giv­ing recog­ni­tion to Ben­jamin Gra­ham who is hailed as the Father of Fun­da­men­tal Analy­sis. Ben­jamin Gra­ham taught finance at Colum­bia Uni­ver­sity and autho­rized two books. His first book “The Intel­li­gent Investor” is con­sid­ered an invest­ment clas­sic. His sec­ond book ” Secu­ri­ties Analy­sis” is con­sid­ered the bible of the Fun­da­men­tal Ana­lyst. Ben­jamin Gra­ham taught War­ren Buf­fet, Charles Munger and William Ruane. It is not coin­ci­den­tal that Graham’s stu­dents are con­sid­ered as icons in the world of invest­ment but rather it is a glow­ing tes­ti­mony to the effi­cacy of Fun­da­men­tal Analy­sis as a method of investing.

Types of Fun­da­men­tal Analy­sis
Although it is gen­er­ally accepted that the aim Fun­da­men­tal Analy­sis is to deter­mine the eco­nomic value of a secu­rity, it is the prac­tice of Fun­da­men­tal Analy­sis that gives rise to two sub types namely Macro-Fundamental Analy­sis and Micro-Fundamental Analysis.

Macro-Fundamental Analy­sis: The Top Down Approach
Macro-Fundamental Analy­sis focuses on broad eco­nomic fac­tors that affect the stock mar­ket as a whole or indus­try groups of secu­ri­ties. This approach is known as the Top Down Approach of Macro-Fundamental Analy­sis. The prac­tice of Macro-Fundamental Analy­sis starts at the over­all per­for­mance of the econ­omy, its impact on indus­try groups and finally down to spe­cific com­pa­nies in the indus­try groups.

It is note­wor­thy that Macro-Fundamental Analy­sis has a more for­mal and struc­tured approach and as such this approach is much favoured by research depart­ments of invest­ment man­age­ment com­pa­nies and bro­ker­age houses.

Micro– Fun­da­men­tal Analy­sis: The Bot­tom Up Approach
Micro-Fundamental Analy­sis starts by con­sid­er­ing the cur­rent price of a stock and com­pares it to mea­sures of value. Hence the cur­rent price of a stock is com­pared to its div­i­dend, its earn­ings, and to its assets result­ing in val­u­a­tion ratios such as its div­i­dend yield, price to earn­ings ratio and its price to asset ratio. The resul­tant val­u­a­tions enable com­par­isons to be made amongst stocks in the same indus­try groups and under­val­ued and over­val­ued stocks are iden­ti­fied by com­par­isons to the indus­trial norm. after this phase of analy­sis, the Micro-Fundamental Analy­sis attempts to pre­dict indus­try and eco­nomic devel­op­ments that may pos­i­tively or neg­a­tively impact the stocks cur­rent price.

It is per­ti­nent to note that invest­ment icons such as Ben­jamin Gra­ham, his prodi­gies War­ren Buf­fet, Charles Munger and William Ruane tend toward Micro-Fundamental Analysis.

Fun­da­men­tal Analy­sis is a struc­tured and for­mal approach to research on a stock’s value and its poten­tial growth. This ana­lyt­i­cal pro­ce­dure facil­i­tates the iden­ti­fi­ca­tion of over­val­ued and under­val­ued stocks rel­a­tive to their earn­ings poten­tial, div­i­dend income poten­tial and to their asset val­ues, against the back­drop of the eco­nomic and indus­try envi­ron­ment. On the basis of the research, invest­ment deci­sions are made such that the odds are stacked in favour of the Fun­da­men­tal Analyst.

By Mr Robert Tay

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