Date: August 14, 2017
” 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 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
Mr Robert Tay is a Dealer’s Representative and has obtained a BA from NUS and MBA from University of New South Wales, Australia. His career in the financial sector spans 25 years of work experience. He lectures regularly at SGX, IBF, NUS and SIAS. He is a member of SIAS Investor Education Advisory Committee