IntroductionThe dilemma faced by the market participants in the secondary market as to predict the movement of stock prices. Due to high volatility in the stock markets it is considered as a very rigorous job to predict the future movement of the stock prices. Fundamental Analysis is the process to predict the future stock prices. Fundamentalists are the market participants who predict movements of stock prices by analyzing the underlying economic conditions upon which they assume changes in the stock prices.

Fundamental Analysis

Fundamental analysis is the study of a company’s financial strength, based on historical data; sector and industry position; management; dividend history; capitalization; and potential for future growth. It is a stock valuation method that uses financial and economic analysis to predict the movement of stock prices. When applied to futures, it focuses on the overall state of the economy, and considers factors including interest rates, production, earnings, employment, GDP, housing, manufacturing and management. The analysis attempts to find the intrinsic value of a security that helps investors to make decisions. The fundamental information that is analyzed can include a company's financial reports, and non-financial information such as estimates of the growth of demand for products sold by the company, industry comparisons, and economy-wide changes, changes in government policies etc.

In fundamental analysis both quantitative tools such as financial ratios from financial statements and qualitative tools such as managerial policies, marketing strategies and product innovation are used to determine the intrinsic value of investment tools. Fundamental analysis stands on the assumption that each security (and market in total) has an intrinsic or integer value based on investor’s estimates. Such value is a function of company’s fundamental variables combined to create expected return and its related risk. One can estimate intrinsic value by evaluating fundamental variables of security value determinants. Then, estimated intrinsic value can be compared to security current price in the market.

Fundamental analysis is performed on historical and present data but with the goal of making financial forecasts. There are several possible objectives:

To conduct a company stock valuation and predict its probable price evolution, To make a projection on its business performance, To evaluate its management and make internal business decisions, To calculate its credit risk.

When analyzing a stock, future contract or currency using fundamental analysis there are two basic approaches one can use; Bottom up analysis and Top down analysis. The term is used to distinguish such analysis from other types of investment analysis, such as Quantitative analysis and Technical analysis.

TOP DOWN AND BOTTOM UP APPROACH

In Top–down analysis, economy/market, industry and firm are analyzed respectively. Economy and market for securities are analyzed to see whether it is the right time to allocate additional sums to stocks or not. Then, industries and sections are analyzed to decide which one has the best outlook in future. Finally, company is analyzed.

In Bottom-up approach, investors focus on firm’s pillars or foundations directly. Analyzing such data as firm’s products, competitive status and financial situation lead to estimate potential profits and, ultimately, its value in the market. In this approach, it is emphasized on finding companies with long term growth perspective and on right estimations on profit.

Figure 1: Top-Down & Bottom-up analysis in Fundamental analysis

Two analytical models:

When the objective of the analysis is to determine what stock to buy and at what price, there are two basic methodologies.

1. Fundamental Analysis: Means that market may misprice a security in the short run but the “correct” price will eventually be reached. Profits can be made by purchasing the mispriced security and then waiting for the market to recognize its “mistake” and re-price the security. Analyzing fundamentals such as earnings, cash flow and assets, is useful in determining buyout and liquidation value of a company. Growth model can be made to gauge potential accumulation in the worth of the company. In short, Fundamental analysts will try to figure out what a stock is really worth versus what it is being traded at.

2. Technical Analysis: Technical analysis says nothing of a company’s finances; it attempts to get inside of the investor. It maintains that all the information is reflected already in the stock price. It does not care what the ‘value’ of a stock is. Technical analysts will always attempt to gauge the current emotional state of buyers to forecast if further buying or selling is likely. Their price predictions are only extrapolations from historic price patterns.

The choice of stock analysis is determined by the investor's belief in the different paradigms for "how the stock market works". For example, many fundamental investors use technical for deciding entry and exit points. Many technical investors use fundamentals to limit their universe of possible stock to good companies.

E-I-C Approach

The approach to fundamental analysis often referred to E-I-C approach. The E-I-C denotes the three parts of the fundamental analysis. They are:

1. Economic Analysis2. Industry Analysis3. Company Analysis

Economic Analysis

Economic analysis is the analysis of forces operating the overall economy of a country. It is a process whereby strengths and weaknesses of an economy are analyzed and is important in order to understand exact condition of an economy. At economy level, fundamental analysts focus on economic indicators and reports to access how well the economy is doing and how well the

economy is going to do in the future. These indicators include GDP, retail sales, inflation and unemployment figures.

Industry Analysis

Industry analysis involves understanding industry supply and demand forces, competition and industry regulation. Often enough, stocks are not lone rangers. They tend to move in groups! Factors such as overall growth rate, market size and importance to the economy are considered when analyzing industry groups.

Company Analysis

Company analysis involves the examination of the balance sheet, the income statement, management, the company’s debt and cash flow. Financial and annual reports are usually being used as research material when forecasting profits of the company stocks. This will help in getting a basic understanding of the pricing in the stock market.

Figure 2: E-I-C Approach

Use by different portfolio styles:

Investors may use fundamental analysis within different portfolio management system.

Buy and hold investors believe that latching onto good businesses allows the investor's asset to grow with the business. Fundamental analysis lets them find 'good' companies, so they lower their risk and probability of wipe-out.

Managers may use fundamental analysis to correctly value 'good' and 'bad' companies. Eventually 'bad' companies' stock goes up and down, creating opportunities for profits.

Managers may also consider the economic cycle in determining whether conditions are 'right' to buy fundamentally suitable companies.

Contrarian investors distinguish "in the short run, the market is a voting machine, not a weighing machine".[2]Fundamental analysis allows you to make your own decision on value, and ignore the market

Value investors restrict their attention to under-valued companies, believing that 'it's hard to fall out of a ditch'. The value comes from fundamental analysis.

Managers may use fundamental analysis to determine future growth rates for buying high priced growth stocks.

Managers may also include fundamental factors along with technical factors into computer models.

Financial Ratios for analysis

Financial analysts use financial ratios to compare the strengths and weaknesses in various companies. If shares in a company are traded in a financial market, the market price of the shares is used in certain financial ratios.

Main types of financial ratios are:

Profitability ratios

Profitability ratios measure the company's use of its assets and control of its expenses to generate an acceptable rate of return. Some profitability ratios are:

Gross margin Operating margin Profit margin ROE ROA

Efficiency ratio Cash flow return on investment Basic earning power ratio Etc.

Liquidity ratios

Liquidity ratios measure the availability of cash to pay debt. Some liquidity ratios are:

Current ratio Quick ratio Cash ratio Operation cash flow ratio Etc.

Activity ratios (Efficiency ratios)

Activity ratios measure the effectiveness of the firms’ use of resources. Some activity ratios are:

DSO Ratio Asset turnover Stock turnover Receivables turnover ratio Cash conversion cycle Payable conversion period Etc.

Debt ratios (leveraging ratios)

Debt ratios quantify the firm's ability to repay long-term debt. Debt ratios measure financial leverage. Some debt ratios are:

Debt ratio Debt to equity ratio Time interest earn ratio Etc.

Market ratios

Market ratios measure investor response to owning a company's stock and also the cost of issuing stock. Some important market ratios are:

EPS ratio Payout ratio P/E ratio Dividend yield Etc.

Capital budgeting ratios

Many formal methods are used in capital budgeting, including the techniques such as:

NPV Profitability index Internal rate of return Equivalent annuity Etc.

By analyzing these ratios one can take correct decision about a company’s position. Financial ratios quantify many aspects of a business and are an integral part of the financial statement analysis. Ratios can also help managers make decisions about investments or projects that the company is considering to take, such as acquisitions, or expansion.

Fundamental Trading

Trading on fundamentals is associated with a ‘buy and hold’ strategy (long-term) rather than a ‘daily/weekly’ (short term) strategy of investing. There are, however, specific instances in which trading on fundamentals can generate some nice profits in a short period.

A good example of a person with successful fundamental trading and investing is Warren Buffet. He has managed to achieve exceptional returns by analyzing company/industry/economy fundamentals and investing in companies he felt were undervalued.

Is Fundamental analysis a traditional way in investing stocks?

This kind of analysis does the comprehensive steps in analyzing, since it does a proper evaluation on firm financial statement and also the qualitative factors associate with the firm. However, there is criticism on fundamental analysis which assuming that doing fundamental analysis is only wasting time. This criticism emerges from the technical analysts and the believer of efficient market hypothesis. Technical analysis basically use by the analyst for the security analysis base on the current price and volume. They tend to use either candlestick chart or line chart and several indicators, in order to predict the momentum of the stock price and ignore the fundamental. Technical analysts also assume that stock price implies all news and latest information on the company. While the theory of efficient market hypothesis is different between both fundamental and technical analysis. This theory state that it is impossible to generate market return in long term, since all stock price is efficiently been priced by the market. So, it is impossible to get any high return derived by fundamental or technical analysis.

Criticisms

Economists such as Burton Malkiel suggest that neither Fundamental analysis nor Technical analysis is useful in outperforming the markets.

Bottom Line

After a brief explanation on how fundamental analysis is work, we know that without this kind of analysis, such investor could not predict the movement of the price for such stock. An analysis should be done in proper manner, starting with the uses of either top down approach or bottom up approach. This is the basic rule of analysis in fundamental. When investors abandoned fundamental analysis before make any investment, they will see the different view of such company. For an example, financial ratio like Price earnings ratio will tell the investor whether current stocks price is overvalue or undervalue. With this ratio also investor can predict the firm growth and how far the price cans roses. But, when investors only depend heavily on technical analysis, all that they will get is sentiment. No brief information how far the stock’s price can increase and the exact figure to evaluate the value of the stocks.As conclusion, fundamental analysis should be used as the main sources or method in investing in stocks, because it can provide all the information needed about the firm and also it value of stocks.