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Introduction
to Fundamental Analysis
Fundamental
analysis involves the use of financial and economic data
to evaluate the liquidity, solvency, efficiency and,
most importantly, the earnings potential of a given
company.
The fundamental
analyst's kitbag of tools includes the corporate annual
report and its financial statements, legal comments by
corporate officers, industry statistics and market
trends, as well as macro-economic data.
With this information in
hand, the fundamental analyst’s goal is to ferret out
undervalued stocks, and then buy them in anticipation of
the appreciation that should occur when this value comes
to light.
While it is not critical
for the average investor to fully understand how the
fundamental analyst goes about his job, it is useful to
have a broad understand of what goes on in his mind when
assessing the value of a share. They place a value on
individual shares by:
Making
projections for the economy as a whole using key
economic indicators
These indicators include
the stock market itself, interest rates, the GDP (Gross
Domestic Product), real business investment, corporate
profits, prices, the balance of payments and the
external value of the dollar.
Stock market
Historically,
a marked downturn in the stock market indicates an
impending recession some six to nine months away. In
these circumstances, it is advisable to sell
economically sensitive shares. Conversely, stocks tend
to turn upward well before the end of a recession.
Thus, a generally good time to buy shares is about six
months after the onset of a recession while the
overall economy is still mired in the shadow of public
gloom.
Interest rates
Falling rates are generally bullish for the economy
and the stock market, while rising rates are bearish,
tending to restrict growth.
Gross Domestic
Product (GDP)
Is a
measure of the health of the nations economy. A
slowdown in the GDP’s rate of growth is negative,
while an increase in growth is positive for the
economy and the share market.
Real business
investment
If companies are spending money to expand markets,
develop new products or build new products, they
obviously expect the economy to be healthy enough to
make a positive return on their investment. When they
cut back, it usually means they are expecting a
downturn.
Corporate profits
Rising profits generally follow an upturn in the
economy, stable profits a transitional period and
falling profits a downturn.
Prices
A little inflation is considered good as it acts to
spur growth and increase corporate profits. However,
too much inflation begins to eat into profits and
could signal a downturn.
Balance of payments
When Australia’s foreign debts rises, the government
and Australian companies have to spend more money to
service the overseas debt. However, when foreign debts
fall, more resources are freed up to fuel expansion at
home.
External value of
the dollar
When the Australian dollar is weak, more of our
internal assets are required for foreign purchases and
debt service, leading to a dampening of our economy.
However, when the dollar is strong, the cost of
foreign financial activities falls and more money is
available for internal investment.
Analysing
a company’s earnings and dividends
As fundamental analysts
examine a company they forecast each company's growth
(or lack thereof) for the next year, as well as for some
reasonable longer-term horizon - such as the next five
years.
Forecasting
the market’s perception of your company’s growth
Once analysts have
predicted the future growth of a company, they then
project how the market will respond to those figures
partly by reviewing the average price/ earnings multiple
(P/E ratio) that the market has assigned to stocks in
the same industry with the same growth rate over the
past few years and extend the trend to encompass the
future earnings they expect.
Next:
An Introduction to Technical Analysis
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