Forecasting Stock Prices With Fundamental Analysis
Fundamental analysis is the traditional model and primary valuation technique used to find a security's intrinsic value
. Fundamental analysis can be used for shorter term trading strategies, but is most effective in determining the intermediate to long term value of assets.
The traditional method analysts use to make stock price forecasts is the top-down approach, beginning with a global macroeconomic forecast. Fundamental analysis is normally conducted through the lens of global and domestic trends. Whether an analyst is using the top-down or bottom-up approach, macro trends often override sector or company-specific patterns.
Analysts narrow their focus by identifying market trends via growth regions, industry groups, and companies. A stock's value can be determined by performing extensive company analysis. This evaluation is performed by looking at the company's operations, business plan, management, and financial history. An analyst examines the vital signs of a company such as earnings, revenue, costs, cash flow, return on equity, and other basic metrics. Analysts usually focus on the top line (revenue) and bottom line (net income) to determine a company's performance. Earnings distributions, like dividends and other cash flows to shareholders, are significant factors in determining the value of a security. A buy-sell signal is given after determining a stock's intrinsic value based on growth and profit & loss forecasts.
Long term trends are projected based on net income and growth forecasts. This type of company analysis is accomplished using balance sheets, income statements, statements of cash flow, and other publically disseminated filings.
Other factors, like strength of management, competitive position within an industry group, and portfolio diversification may factor into the buy-sell decision. Management competency can be observed through the company's financial track record and business plan for the future. A company's competitive position can be determined based on market capitalization and sales forecasts compared with firms with similar operations. Portfolio diversification needs may alter the decision making process as well.
This type of financial analysis requires a level of proficiency in evaluation and forecasting. Earnings and growth estimates require subjective valuations for inputs like risk premiums and other forecasts. Fundamental analysis is also more time consuming than other methods as financial statement analysis of individual companies represents the most expansive portion of fundamental analysis.
Stock price forecasts and predictions can be influenced by a variety of factors, including technical trading rules that are based largely on emotionally factors of the market. Traders are increasingly conjoining technical analysis in addition to fundamental analysis to remove much of the subjectivity involved in finding a stock's intrinsic value. Some traders augment fundamental analysis by identifying market trends through charting techniques.
Quantitative analysis and computer modeling are additional methods used to predict stock prices. Using a large quantity of data, quants seek out stock values using mathematical formulas and simulated models.
Although technical and quantitative analysis is a growing percentage of the marketplace, fundamental analysis remains the core method by which market participants value security prices. Hedge funds, mutual funds, and other large financial institutions rely primarily on the skills of fundamental analysts to value and predict stock prices. Individual investors would be well-served by acquiring a grounding in the basics of fundamental analysis.
by: Matt kaldor
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