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Fundamental Analysis

Fundamental Analysis

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Published by: Abhinandan Chatterjee on Oct 27, 2009
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09/26/2010

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Fundamental AnalysisWhat isFundamental Analysis?
Fundamental analysisis the examinationof the underlyingfor ces thataffect the well beingof the economy, industry groups,and companies.As with mostanalysis, the goal is to derivea for ecastand pr of it from future price movements.At the company level,fundamental analysismay involve examination of financial data, management, business conceptand competition.At the industry level, there might bean examinationof supplyand demandfor cesfor the productsof fered.For the national economy, fundamental analysismight focus on economic datatoassess the presentand future growthof the economy. Tofor ecast future stock prices,fundamental analysiscombines economic, industry,and companyanalysisto deriveastock's current f air valueandfor ecast future value. If f air value is not equal to the current stock price,fundamental analysts believe that the stock is either over or under valuedand the market price will ultimately gr avitate towards f air value.Fundamentalists do not heed theadviceof the andom walkersand believe that marketsare weak-for m efficient. By believing that prices do not accur ately reflectallavailable infor mation,fundamental analysts look to capitalize on perceived price discrepancies.
Gener alStepstoFundamentalEvaluation
Even though there is no one clear-cut method,abreakdown is presented below in the order an investor  might proceed. This method employsatop-downapproach that starts with the over all economyand then works down from industry groups to specific companies.As partof theanalysisprocess, it is important to remember thatall infor mation is relative. Industry groupsare comparedagainst other industry groupsand companiesagainst other companies. Usually, companiesare compared with others in the same group. For example,atelecom oper ator (Verizon) would be compared toanother telecom oper ator (SBC Corp), not toan oil company (ChevronTexaco).
EconomicFor ecast
Firstandfor emost inatop-downapproach would bean over all evaluationof the gener al economy. The economy is like the tideand the various industry groupsand individual companiesare like boats. When the economy expands, most industry groupsand companies benefitand grow. When the economy declines, most sectorsand companies usually suffer. Many economists link economic expansionand contr action to the levelof interest r ates. Interest r atesare seenasaleading indicator for the stock market as well. Below isachartof the S&P 500and the yield on the 10-year note over the last 30 years. Although not exact,acorrelation between stock pricesand interest r ates can be seen. Onceascenario for the over all economy has been developed,an investor can break down the economy into its various industry groups.
 
Group Selection
If the prognosis isfor  an expanding economy, then certain groupsare likely to benefit more than others. An investor can narrow the field to those groups thatare best suited to benefit from the current or future economic environment. If most companiesare expected to benefit froman expansion, then risk in equities would be relatively lowandanaggressive growth-oriented str ategy might beadvisable.Agrowth str ategy might involve the purchaseof technology, biotech, semiconductor and cyclical stocks. If the economy is for ecast to contr act,an investor may optfor  amore conservative str ategyand seek out stable income- oriented companies.Adefensive str ategy might involve the purchaseof consumer staples, utilitiesand energy-related stocks.Toassessaindustry group's potential,an investor would want to consider the over all growth r ate, market size,and importance to the economy. While the individual company is still important, its industry group is likely to exert justas much, or more, influence on the stock price. When stocks move, they usually move as groups; thereare 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 per for manceof 5 sectors over a7- month time fr ame.As the chart illustr ates, being in the right sector can makeall the difference.
 
Narrow Within the Group
Once the industry group is chosen,an investor would need to narrow the listof companies befor e proceeding toamore detailedanalysis. Investorsare usually interested in finding the leadersand the innovators withinagroup. The first task is to identify the current businessand competitive environment withinagroupas wellas the future trends. How do the companies r ankaccording to market share, product positionand competitiveadvantage? Who is the current leader and how will changes within the sector affect the current balanceof power? Whatare the barriers to entry? Success depends onan edge, be it marketing, technology, market share or innovation.Acompaativeanalysis of the competition within asector will help identify those companies withan edge,and those most likely to keep it.
CompanyAnalysis
Withashortlistof companies,an investor mightanalyze the resourcesand capabilities within each company to identify those companies thatare capableof creatingand maintainingacompetitive advantage. Theanalysiscould focus on selecting companies withasensible business plan, solid managementand sound financials. Business PlanThe business plan, model or conceptfor ms the bedrock upon whichall else is built. If the plan, model or  concepts stink, there is little hopefor the business.For  anew business, the questions may be these: Does its business make sense? Is it feasible? Is thereamarket? Canapr of it be made?For  an established business, the questions may be: Is the company's direction clearly defined? Is the companya leader in the market? Can the company maintain leadership? Management In order to executeabusiness plan,acompany requires top-quality management. Investors might lookat management toassess their capabilities, strengthsand weaknesses. Even the best-laid plans in the most dynamic industries can go to waste with bad management (AMD in semiconductors).Alternatively, even strong management can makefor extr aordinary success inamature industry (Alcoainaluminum). Some of the questions toask might include: How talented is the management team? Do they haveatr ack

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