In theory, the fair value of a bond or an equity share is the sum of the discounted value of the likely future cash flows.
The assessment is simpler in a bond, as the cash flows are predefined and end at a given point in time.
Equity earnings are not pre-defined and equity is auninterrupted investment with no pre-set maturity date.
The focal point in equity assessment is on the future earnings and the estimates of growth in earnings.
Fundamental analysts uphold that market may misprice securities in the short run but in the long run, prices would combine with the securities’ fair value or inherent value. Consequently, profits in investments come from not only identifying a good investment option but also making the investment at the right price.
This thought process is in disagreement of Efficient Market Hypothesis (EMH), which disseminates that share prices incorporate and reflect all pertinent information.
Fundamental analysis deems both qualitative and quantitative dimensions of a business.
While financials will disclose history of the business and the financial readiness to grow in the future, estimateaspects such as the economic conditions constructive to the business, the ability of the management to identify and exploit opportunities, the operating efficiencies that the business possesses and the risks that may affect the strategy and its skill to meet these eventuality, will define the attractiveness of the business as an investment scheme.
For that reason, fundamental analysis includes following:
A. Economic analysis B.Industry analysis C. Company analysis
Fundamental analysis could also be triggered by changing macro-economic factors, each international and national, like GDP growth rates, inflation, interest rates, exchange rates, productivity, costs of commodities, regulatory aspects and others. This can guide to an analysis of their impact on different industries and then to search to the best businesses in the industry.
This is knowntop-down approach to fundamental research. For instance, the regulatory uncertainty regarding spectrum auction in the telecom sector in India would trigger a re-look at the industry’s prospects and its impact on the different companies in the sector..
On the other hand, sometimes analysis is activated by some news or piece of information on some company, which may move to industry analysis and then economic analysis to see whether broad industry and economic parameters favour the corporate.This is known asbottom-upapproachto fundamental research..
Certainly, at times, bottom-up analysts focus purely on dynamics of business and industry with little or no attention to the Economic factors as their focus remains on buying and holding primarily strong businesses which would perhaps do well across the economic cycles, such as pharmaceuticals, consumer goods and other such businesses..