Chapter 7

Fundamental Analysis

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Analysis

• Mass of data requires techniques to be used• Different user requirements• Goal of process is ‘informed decision-making’• Challenges are how to:

• contextualise• compare

• Fundamental Analysis / Technical Analysis

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Fundamental Analysis (FA)

• Focus on business fundamentals• Macro- and Micro- issues

• economy• competitors• financial performance

• Principal techniques:• common-size statements• ratios (percentages, etc.)

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Common-size Statements

• Provide a common base• e.g., express all as % of sales

• Enables comparison:• cross-sectional• segmental• temporal

• May remove size as explanatory variable

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Ratios

• Reduce information to common form• Enable inter-firm comparison

• Categories:• liquidity• activity• financing• profitability• investment

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Use of ratios

• Ratios only one part (Calculation) of process• Overall process can be summarised as OCAID:

• Observation: assessment of available information

• Calculation: reduction to other forms e.g. ratios

• Analysis: initial contextualization

• Interpretation: identification/evaluation of significance

• Decision-making: goal of FIA

• Art/Skill

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Ratios: Issues/Problems

• Ratios only a means to an end• Perpetuate problems in accounting data• Assumptions not always sustainable • Benchmarking a useful technique• Statistical issues:

• negative numbers• small numbers• numerator/denominator

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Technical Analysis (TA)

• ‘Patterns can be captured, understood and predicted’• e.g. share price movements can be predicted

• Charles Dow • Trends

• primary• secondary

• Not normally used for long-term investment• Increasingly, used in tandem with FA:

• Fundamental Analysis: WHAT to buy;• Technical Analysis: WHEN to buy

Financial Information Analysis 9Copyright 2006 John Wiley & Sons Ltd

Summary

• Techniques developed to aid decision-making:• Fundamental Analysis - WHAT• Technical Analysis - WHEN

• Fundamental Analysis:• analyses commercial, economic contexts etc.• uses ratios, etc. for comparison and analysis

• This course based primarily on Fundamental Analysis

• Process summarised as OCAID