An investment is a commitment of funds for a period of time to derive a rate of return that would compensate the investor for the time during which the funds are invested, for the expected rate of inflation during the investment horizon, and for the uncertainty involved. An investment decision process is similar to the one you follow when shopping for clothes or a car. In each case, you examine the item and decide how much it is worth to you. If the price equals or is less than its estimated value, you buy it. The same technique applies to securities.
Fundamental analysis is basically a tool that attempts to determine a security's value by focusing on the underlying basic factors that affect a company's actual business and its future prospects. Fundamental analysis of shares involves aggregate market analysis on the basis of basis of sales, earnings, cash flows, and risk factors followed by industry and company analyses. So, it is also called a top-down or three-step approach.
Monetary and fiscal policy measures enacted by various governments influence the aggregate economies of those countries. The resulting economic conditions influence all industries and companies. Also, such events as war, political upheavals in foreign countries, or international monetary devaluations produce changes in the business environment that add to the uncertainty of sales and earnings expectations and, therefore, the risk premium required by investors. It is difficult to conceive of any industry or company that can avoid the impact of macroeconomic developments that affect the total economy. Therefore, aggregate economic events should be considered before analysing industries.
The objective of industry analysis is to identify global industries that will prosper or suffer in the long run or during the expected near-term economic environment. In general, an industryís prospects within the global business environment will determine how well or poorly an individual firm will fare. So, industry analysis should precede company analysis. Few companies perform well in a poor industry, so even the best company in a poor industry is a bad prospect for investment.
After determining an industryís outlook, an investor can analyse and compare individual firmsí performance within the industry using financial ratios and cash-flow values. The objective is to identify the best company in a promising industry. This involves examining a firmís past performance and future prospects. After you understand the firm and its outlook, you can determine its value. As a final step, you compare the estimated Ďintrinsicí value to the price of the firmís stock and decide whether it is a good investment. Your final goal is to select the best stock/bonds within the industry and include it in your portfolio based on its relationship with all other assets in your portfolio.
Advocates of the top-down, three-step approach believe that both the economy/market and the industry effect have a significant impact on the total returns for individual stocks. All forms of fundamental analysis are useful, but the success depends on how well we are able to estimate future values for relevant economic variables.
The writer is an associate professor in finance & accounting in IIM Shillong