Fundamental Analysis
From Financial Literacy Wiki
Fundamental analysis seeks to identify undervalued stocks by studying the economic performance of countries and industries, by looking at economic indicators, as well as a firm’s business prospects by looking at financial ratios. Fundamental analysts believes that each stock has an intrinsic value. The intrinsic value is also known as the fundamental value or fair price.
The fair price is obtained by discounting the stock’s future expected dividends and a future expected price. All things being equal, the better the earnings prospects of a firm and the higher its growth rate, the higher is its fair price.
Since a firm’s business prospects is tied to the performance of the economy and the industry in which it operates, some analysts adopt a top-down approach in which the analysis begins with a forecast of the economy, followed by detailed analysis of industry prospects and their implication for the firm. Based on these assessments, the analyst then estimates how much the stock is intrinsically worth. Given that so many factors impinge on a stock’s price, determining the intrinsic value of a stock requires considerable judgement. Some investors use numerical valuation models such as dividend discount model or free cash-flow model. Others rely on simple value screens such as PE ratio and PB ratio to pick stocks.
Once the intrinsic value of a firm’s share is determined, the investor can adopt the investment rule given below:
- If Current Market Price of stock is equal to intrinsic value, do not take actions.
- If Current Market Price of stock is less than the intrinsic value, buy stock.
- If Current Market Price of stock is more than the intrinsic value, sell stock.
