Fundamental analysis defined
Fundamental analysis is based on the notion that the true value of a share is solely determined by the expected stream of future benefits to the shareholder. This true vale of a share is termed the share's intrinsic value. More specifically, the intrinsic value is the price an investor would pay for a stock if all relevant information regarding its anticipated future benefits was both available and properly analyzed. The method of finding the intrinsic value of a security is called fundamental analysis.
Aim of fundamental analysis
Followers of fundamental analysis - fundamentalists - believe that the market price of a stock tends to move toward its instinct value. The objective of the fundamentalist is to use superior information or information-processing techniques to identify these mispriced securities. Superior returns may then be earned by either purchasing underpriced securities or short-selling overpriced securities.
The fundamentalist usually has time horizon of at least six months and often longer. This type of analysis does not attempt to forecast stock price moves on a daily basis. That task is more often reserved for technical analysts.
Fundamental Analysis and efficient markets
The fundamentalist hopes to earn a superior return as a result of having better access to relevant information, or a better ability to process it. A market in which all relevant information is currently reflected in present share prices is called an efficient market. In a perfectly efficient market there would be no need for the output of fundamentalists, since current share price would be the best estimate of intrinsic value. On the other hand, the only way for a market to become efficient is through the efforts of a number of reasonably capable fundamentalists who constantly make intrinsic value estimates. This creates a paradox; while stock markets appear to be efficient, they can only continue to be efficient through the efforts of a large number of fundamentalists who believe the market is not efficient. Furthermore, the purchase of stocks that are deemed to be priced below their intrinsic value only makes senses if prices ultimately tend to adjust toward intrinsic values.
Steps in fundamental analysis
The fundamentalist is basically concerned with two issues: the future benefits to be derived from the share, and what the market is willing to pay for these future benefits. The first step in fundamental analysis is to acquire all possible information that will help to assess the future benefits to be derived from the stock. This step typically involves an analysis of the individual firm. Second, the analyst uses all of this data to forecast the firm's future earnings and dividends and to access the likelihood of them being realized. Finally, the fundamentalist determines the appropriate price to be paid for these future benefits in the light of their uncertainty and overall capital market conditions.
