Fundamental Analysis

• The Fundamental Analysis: Fundamentalists believe the market is only 10% psychological and 90% logical and care little about the pattern of past price movement. They are concerned with determining a stock's value, based on expected growth rates of earnings and dividends, interest rates, and risk. If they believe the intrinsic value of a security is above the market price, the investor is advised to buy. The semi-strong and strong forms of the efficient-market hypothesis attack fundamental analysis. A news event such as an announcement of an unexpected large increase in earnings triggers a 'buy' singnal, but the market is so efficient in adjusting to new information that it is impossible to devise successful trading strategies on the basis of new announcements. No one can buy or sell fast enough to benefit.
  • Basic tenets of the theory: buying and holding a broad-based market index fund produces the most profitable and most successful returns.
  • Cardinal rule of stock selection: look for companies with good growth prospects that have yet to be discovered by the stock market and therefore are selling at low earnings multiples. This approach is called GARP, growth as a reasonable price. If growth does materalize, both the earnings multiple will likely increase, giving the investor a double benefit.

• Examples of Fundamental Analysis Questions:
  • Is the company's revenue growing?
  • Are they actually making a profit?
  • Are they in a strong enough position to beat out their competitors?
  • Are they able to repay their debts?

• Flaws

1. Information and analysis may be incorrect

If any of this information is wrong, it will skew estimates of rate of growth of earnings and dividends. These are two large factors of determining a stocks value.

2. Security analysts estimate of "value" may be faulty

It is difficult to translate estimates of growth into a single estimate of intrinsic value.

3. Market may not correct its price mistake and the stock price may not converge to its value estimate.

Example:

Suppose company X is selling at 30 times earnings, and the analyst estimates that it can sustain a long-term growth rate of 25 percent. If, on average, stocks with 25 percent anticipated growth rates are selling at 40 times earnings, the fundamentalist might conclude that company X was a "cheap" stock and recommend purchase. But suppose a few months later stocks with 25 percent growth rates are selling in the market at only 20 times earnings. Even if the analyst was absolutely correct in his growth-rate estimate, his customers might not gain, because the market revalued its estimates of what growth stocks in general were worth. The market might correct its "mistake" by revaluing all stocks downward, rather than raising the price for company X.

---

Random Walk | Speculative Bubbles | Fundamental Analysis | Technical Analysis | Efficient-Market Hypothesis | Non-Random Walk Theory | Market Efficiency vs. Behavioral Finance