Fundamental Analysis in Investment¶
Investment Scenario¶
Investing involves allocating funds to assets with the goal of earning income or capital appreciation. It implies sacrificing current consumption in anticipation of future returns. The essence of investment can be distilled into three key aspects:
- Return: The income generated from the investment.
- Risk: The uncertainty associated with the return.
- Time: The period over which the investment is expected to generate returns.
Investment decisions revolve around two primary questions: 1. What securities should be included in the portfolio? 2. How much capital should be allocated to each security?
These decisions are made through a three-step process: 1. Security Analysis 2. Security Evaluation 3. Portfolio Analysis, Selection, and Management
Security Analysis¶
Traditional security analysis focuses on projecting future prices and dividends of a company's stock, then discounting them back to their present value. However, modern security analysis goes beyond mere price and dividend forecasts. It emphasizes estimating risks and returns, considering the price of shares and the expected dividend stream.
Security Evaluation¶
Security evaluation involves assessing the true worth of a security before investing. It requires a thorough comparison between the security's market price and its intrinsic value. The market price is what the security is currently traded for on the stock exchange, while intrinsic value represents the security's true worth. Only through such evaluation can an investor decide whether to buy, hold, or sell a security.
Different Approaches to Evaluation¶
- Fundamental Approach/Analysis
- Technical Approach/Analysis
- Modern Approach/Analysis
Fundamental Approach/Analysis¶
Fundamental analysis evaluates a company's stock price by examining its financial data. This method looks at various aspects such as earnings, expenses, profits, assets, liabilities, management experience, and industry dynamics to determine what the stock price should be. An investor using fundamental analysis relies on sources of information like:
- Company Balance Sheets
- Income (Profit and Loss) Statements
- Annual Reports
- Newspapers
- Company Announcements
- Industry News
Fundamental analysis aims to answer critical questions about a company:
- Is the company's revenue growing?
- Is it making a profit?
- Can it outperform its competitors in the future?
- Is it capable of repaying its debts?
- Is the management trustworthy and transparent?
By answering these questions, investors using fundamental analysis can make informed decisions about which securities to invest in and how much capital to allocate to each.
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