Fundamental Analysis

Fundamental analysis is one of the two main approaches used to predict the future movement of the price of a stock. The other approach is technical analysis; where the  practitioner uses charts to look for trends in how the price of the stock has moved. In technical analysis, trends are seen as a way of identifying possible future price movements. as the assumption is made that investors will react to events in the future in similar ways that they have done in the past.

Burton G. Malkiel discusses the difference between these two approaches in his classic investment book ‘A Random Walk Down Wall Street.’ Malkiel says that ‘the technician is only interested in the record of the stock’s price, whereas the fundamentalist’s most important job is to estimate the firms future stream of earnings and dividends.’

In attempting to estimate the future earnings and dividends that a company will generate and pay, the practitioner of fundamental analysis will take a number of things into account. The list below gives some examples of these factors:

1. The state of the economy and the industry that the company operates in and future expectations. For example, if the economy is growing quickly and mobile broadband services are being bought in increasing volumes by consumers, a company with a strong stake in this market will be in a good position to see it’s future earnings grow

2. The competitive position that faces the company. There may be strong competition in the industry the company operates in and this may lead to price wars; for example, in the retail industry. These developments may impact the future earnings growth of the companies operating in this industry

3. The technological position facing the industry the company operates in. For example, if new methods of production are in the course of being developed, the future earnings of the company may be increased if they can take advantage of new machinery

4. Specific analysis of the company and its recent performance. The practitioner will examine key measures and see their trends in recent years and months. These measures will include the amount of earnings growth that the company has seen, the firms sales levels and how they are trending, operating costs and dividend growth

5. Specific analysis of the company and its future projections. The practitioner will also look to the key measures identified to see what the future projections are for the company. Key measures will include projected profit, sales, earnings and dividend growth rates. The practitioner of fundamental analysis will then take a view on whether the projections are indeed realistic

There are a number of key ratios that the practitioner of fundamental analysis will look to when analysing a stock. These include the price/ earnings ratio and earnings per share. By comparing these ratios to those achieved by other companies in the industry and the stock market overall, the analyst will have an indication if the stock is cheap or expansive.

Critics of fundamental analysis point out that there are a number of reasons why the analysis may prove to be suspect. These factors include the possibility that the stock price may not move in line with the true value of the company. In addition, it is possible that some of the figures used or assumptions made may prove to be inaccurate. As a result, a number of leading stock market investors use a combination of fundamental and technical analysis to predict future stock price movements.