Notes

Notes
Fund*ment*l *n*lysis of %
business involves %n%lyzing
its fin%nci%l st%tements %nd
he%lth, its m%n%gement %nd
competitive %dv%nt%ges, %nd
its competitors %nd m%rkets.
When %pplied
to futures %nd forex, it focuses on
the over%ll st%te of the economy,
interest r%tes, production,
e%rnings, %nd m%n%gement.
When %n%lyzing % stock, futures
contr%ct, or currency using
fund%ment%l %n%lysis there %re
two b%sic %ppro%ches one c%n
use; bottom up %n%lysis %nd top
down %n%lysis. The term is used
to distinguish such %n%lysis from
other types of investment
%n%lysis, such %s qu%ntit%tive
%n%lysis %nd technic%l %n%lysis.
Fund%ment%l %n%lysis is
performed on historic%l %nd
present d%t%, but with the go%l of
m%king fin%nci%l forec%sts. There
%re sever%l possible objectives:
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to conduct % comp%ny stock
v%lu%tion %nd predict its
prob%ble price evolution,
to m%ke % projection on its
business perform%nce,
to ev%lu%te its m%n%gement
%nd m%ke intern%l business
decisions,
to c%lcul%te its credit risk.
Use by different portfolio
styles
Investors m%y use fund%ment%l
%n%lysis within
different portfolio m%n%gement st
yles.
Buy *nd hold investors
believe th%t l%tching onto
good businesses %llows the
investorʼs %sset to grow with
the business. Fund%ment%l
%n%lysis lets them find
‘goodʼ comp%nies, so they
lower their risk %nd
prob%bility of wipe-out.
M%n%gers m%y use
fund%ment%l %n%lysis to
correctly v%lue ‘goodʼ %nd
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‘b%dʼ comp%nies. Eventu%lly
‘b%dʼ comp%niesʼ stock goes
up %nd down, cre%ting
opportunities for profits.
M%n%gers m%y %lso consider
the economic cycle in
determining whether
conditions %re ‘rightʼ to buy
fund%ment%lly suit%ble
comp%nies.
Contr*ri*n investors distin
guish “in the short run, the
m%rket is % voting m%chine,
not % weighing
m%chine”. Fund%ment%l
%n%lysis %llows you to m%ke
your own decision on v%lue,
%nd ignore the m%rket.
V*lue investors restrict
their %ttention to underv%lued comp%nies, believing
th%t ‘itʼs h%rd to f%ll out of %
ditchʼ. The v%lue comes from
fund%ment%l %n%lysis.
M%n%gers m%y use
fund%ment%l %n%lysis to
determine future growth
r%tes for buying high
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priced growth stocks.
M%n%gers m%y %lso include
fund%ment%l f%ctors %long
with technic%l f%ctors into
computer models
(qu%ntit%tive %n%lysis).
Top-down 3nd bottom-up
Investors c%n use either % topdown or bottom-up %ppro%ch.
The top-down investor st%rts
his %n%lysis with glob%l
economics, including both
intern%tion%l %nd
n%tion%l economic
indic%tors, such
%s GDP growth
r%tes, infl%tion, interest r%tes
, exch%nge
r%tes, productivity, %nd
energy prices. He n%rrows
his se%rch down to region%l/
industry %n%lysis of tot%l
s%les, price levels, the
effects of competing
products, foreign
competition, %nd entry or
exit from the industry. Only
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then he n%rrows his se%rch
to the best business in th%t
%re%.
The bottom-up investor
st%rts with specific
businesses, reg%rdless of
their industry/region.
Procedures
The %n%lysis of % businessʼ he%lth
st%rts with fin%nci%l st%tement
%n%lysis th%t includes r%tios. It
looks %t dividends p%id, oper%ting
c%sh flow, new equity issues %nd
c%pit%l fin%ncing. The e%rnings
estim%tes %nd growth r%te
projections published widely
by Thomson Reuters %nd others
c%n be considered either
‘fund%ment%lʼ (they %re f%cts) or
‘technic%lʼ (they %re investor
sentiment) b%sed on your
perception of their v%lidity.
The determined growth r%tes (of
income %nd c%sh) %nd risk levels
(to determine the discount r%te)
%re used in v%rious v%lu%tion
models. The foremost is
the discounted c%sh flow model,
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which c%lcul%tes the present
v%lue of the future
dividends received by the
investor, %long with the
eventu%l s%le price. (Gordon
model)
e%rnings of the comp%ny, or
c%sh flows of the comp%ny.
The %mount of debt is %lso %
m%jor consider%tion in
determining % comp%nyʼs he%lth.
It c%n be quickly %ssessed using
the debt to equity r%tio %nd
the current r(tio (current %ssets/
current li%bilities).
The simple model commonly used
is the Price/E%rnings r%tio. Implicit
in this model of % perpetu%l
%nnuity (Time v%lue of money) is
th%t the ‘flipʼ of the P/E is the
discount r%te %ppropri%te to the
risk of the business. The multiple
%ccepted is %djusted for
expected growth (th%t is not built
into the model).
Growth estim%tes %re
incorpor%ted into the PEG r%tio,
but the m%th does not hold up to
%n%lysis. Its v%lidity depends on
the length of time you think the
growth will continue. IGAR models
c%n be used to impute expected
ch%nges in growth from current P/
E %nd historic%l growth r%tes for
the stocks rel%tive to %
comp%rison index.
Computer modelling of stock
prices h%s now repl%ced much of
the subjective interpret%tion of
fund%ment%l d%t% (%long with
technic%l d%t%) in the industry.
Since %bout ye%r 2000, with the
power of computers to crunch
v%st qu%ntities of d%t%, % new
c%reer h%s been invented. At
some funds (c%lled Qu%nt Funds)
the m%n%gerʼs decisions h%ve
been repl%ced by propriet%ry
m%them%tic%l models.