What is Fundamental Analysis?
Fundamental analysis attempts to determine the present value of a stock based on its expected future cash flows.
Present value is the aggregate of all future cash flows discounted to their current value. Cash flows are discounted by converting their future value to an equivalent current value using a discount rate.
The discount rate includes two components:
- a risk-free rate of interest (usually the yield on treasury notes or bonds), and
- a premium to compensate investors for the increased risk associated with uncertain future cash flows.
Expected Future Cash Flows
Expected future cash flows are the investor's/analyst's assessment of future
cash flows based on their assessment of the present position and future
prospects of a company. See Value Investing
for further details.
The most common mistake is to prepare a detailed assessment of value without recognizing the uncertainty surrounding many of the assumptions on which your valuation is based:
- The current financial structure may improve or deteriorate;
- The operating environment may radically alter:
- new legislation or new tariffs or taxes;
- competitors introduce new products;
- new technologies or substitute products;
- new distribution channels;
- raw material surpluses or shortages;
- labor market changes;
- changes in consumer tastes;
- financing costs rise or fall; or
- wars, pestilence and natural disasters may affect the ability to trade.
- New ventures may succeed or fail spectacularly;
- Litigation is a continual risk - from class actions, copyright or patent infringements, and antitrust violations; and
- Management may succeed beyond expectations or fail dismally.
In many cases the analysts best estimate of a company's future prospects is no more than a shot in the dark.
Fundamental Analysis versus Technical Analysis
There is a long-standing debate on the forum between fundamental and technical analysts, each camp claiming that their method is better. What they seem to have lost sight of is that they are talking about different time frames. Short and medium-term price fluctuations tend to be driven by market sentiment rather than changes in the intrinsic value of a stock, while in the long-term price tends to converge with intrinsic value -- or at least the consensus view of intrinsic value among the major market players.
Technical analysis is ideally suited to short- or medium-term investing, while fundamental analysis, or a combination of technical and fundamental analysis (called active investing), is more suited to the long term.
Analysts tend to place too much emphasis on their valuation model because it is the one area where they can achieve a fair degree of precision. The importance of the valuation model is comparatively insignificant when compared to the importance of making the correct assumptions.