Fundamental analysis is a technique that attempts to determine a security’s value by focusing on underlying factors that affect a company’s actual business and its future prospects. On a broader scope, you can perform fundamental analysis on industries or the economy as a whole. The term simply refers to the analysis of the economic well-being of a financial entity as opposed to only its price movements.
Fundamental analysis serves to answer questions, such as:
Is the company’s revenue growing?
Is it actually making a profit?
Is it in a strong-enough position to beat out its competitors in the future?
Is it able to repay its debts?
Is management trying to “cook the books”?
Of course, these are very involved questions, and it all really boils down to one question: Is the company’s stock a good investment? Think of fundamental analysis as a toolbox to help you answer this question.
The Concept of Intrinsic Value
Before we get any further, we have to address the subject of intrinsic value. One of the primary assumptions of fundamental analysis is that the price on the stock market does not fully reflect a stock’s “real” value. After all, why would you be doing price analysis if the stock market were always correct? In financial jargon, this true value is known as the intrinsic value.
For example, let’s say that a company’s stock was trading at Rm 3.00. After doing extensive homework on the company, you determine that it really is worth Rm 4.00. In other words, you determine the intrinsic value of the firm to be Rm 4.00. This is clearly relevant because an investor wants to buy stocks that are trading at prices significantly below their estimated intrinsic value.
This leads us to one of the second major assumptions of fundamental analysis: in the long run, the stock market will reflect the fundamentals. There is no point in buying a stock based on intrinsic value if the price never reflected that value. Nobody knows how long “the long run” really is. It could be days or years.
This is what fundamental analysis is all about. By focusing on a particular business, an investor can estimate the intrinsic value of a firm and thus find opportunities where he or she can buy at a discount. If all goes well, the investment will pay off over time as the market catches up to the fundamentals.
The big unknowns are:
1)You don’t know if your estimate of intrinsic value is correct; and
2)You don’t know how long it will take for the intrinsic value to be reflected in the marketplace.
Criticisms of Fundamental Analysis
The biggest criticisms of fundamental analysis come primarily from two groups: proponents of technical analysis and believers of the “efficient market hypothesis”.
Technical analysis takes a completely different approach; it doesn’t care one bit about the “value” of a company. Chartists are only interested in the price movements in the market.
Despite all the fancy and exotic tools it employs, technical analysis really just studies supply and demand in a market in an attempt to determine what direction, or trend, will continue in the future. In other words, technical analysis attempts to understand the emotions in the market by studying the market itself, as opposed to its components. If you understand the benefits and limitations of technical analysis, it can give you a new set of tools or skills that will enable you to be a better trader or investor.
You can use technical analysis to:
- Identify profitable stock patterns
- Minimize your risk
- Maximize your return in up and down markets
You’ll learn how to make big money on stocks using a technical analysis toolkit that has been wielded successfully for hundreds of years. That’s no exaggeration.
Put simply, technical analysts base their investments (or, more precisely, their trades) solely on the price and volume movements of securities. Using charts and a number of other tools, they trade on momentum, not caring about the fundamentals. While it is possible to use both techniques in combination, one of the basic tenets of technical analysis is that the market discounts everything. Accordingly, all news about a company already is priced into a stock, and therefore a stock’s price movements give more insight than the underlying fundamental factors of the business itself.
Efficient Market Hypothesis
Followers of the efficient market hypothesis, however, are usually in disagreement with both fundamental and technical analysts. The efficient market hypothesis contends that it is essentially impossible to produce market-beating returns in the long run, through either fundamental or technical analysis. The rationale for this argument is that, since the market efficiently prices all stocks on an ongoing basis, any opportunities for excess returns derived from fundamental (or technical) analysis would be almost immediately whittled away by the market’s many participants, making it impossible for anyone to meaningfully outperform the market over the long term.
Random Walk Theory
As mentioned above, if all the shares would have been efficiently priced, how can you make money? In the Random Walk Theory, this is the idea that stocks take a random and unpredictable path. A follower of the random walk theory believes it’s impossible to outperform the market without assuming additional risk. Critics of the theory, however, contend that stocks do maintain price trends over time – in other words, that it is possible to outperform the market by carefully selecting entry and exit points for equity investments.
As I am not an accountant, I use my common sense to select shares, like buying a small part of a business. It must be a business with long term good profit growth prospect. It must be undervalued and not many analysts write about it. I do not buy famous stocks which are frequently in the news because they would have been fully priced.
Although buying bank shares are very safe, I do not buy them because their rate of return is not good enough for me.
I also do not buy property development shares because I think the supply is more than demand as you can see currently there are so many vacant properties unsold. That is why banks have imposed stricter loan conditions to discourage speculation. As a result, there are many property company shares are selling below their NTA.
My share selection golden rule: Before I buy any share, I must be sure that the company can make more profit in the current year than last year because when it shows increasing profit the share price will go up. But if it announces reduced profit, the share price will surely fall.
Conclusion: How to make profit?
After you have bought some shares basing on one or a combination of two or more methods as mentioned above, you must sell to make profit. You must bear in mind that no share will continue to go up in price for whatever reasons and no share will continue to come down for whatever reason. To make profit, you must not fall in love with the shares you have bought and keep them forever. You must sell so that you have money to buy the same share when the price makes a correction or buy another share that comply with my golden rule. .
Like most investors, I frequently have difficulty to decide when to sell to make profit. The best time to sell is when I see that the company is showing reduced quarterly profit or when the reason to buy it is no long valid. If the company continues to show increasing quarterly profit, I do not sell it.
Now, what you need is some LUCK which is what happens when preparation meets opportunity.