Introduction

The dilemma faced by the market participants in the secondary market as to predict the
movement of stock prices. Due to high volatility in the stock markets it is considered as a very
rigorous job to predict the future movement of the stock prices. Fundamental Analysis is the
process to predict the future stock prices. Fundamentalists are the market participants who
predict movements of stock prices by analyzing the underlying economic conditions upon which
they assume changes in the stock prices.

Fundamental Analysis

Fundamental analysis is the study of a companys financial strength, based on historical data;
sector and industry position; management; dividend history; capitalization; and potential for
future growth. It is a stock valuation method that uses financial and economic analysis to predict
the movement of stock prices. When applied to futures, it focuses on the overall state of the
economy, and considers factors including interest rates, production, earnings, employment, GDP,
housing, manufacturing and management. The analysis attempts to find the intrinsic value of a
security that helps investors to make decisions. The fundamental information that is analyzed can
include a company's financial reports, and non-financial information such as estimates of the
growth of demand for products sold by the company, industry comparisons, and economy-wide
changes, changes in government policies etc.
In fundamental analysis both quantitative tools such as financial ratios from financial statements
and qualitative tools such as managerial policies, marketing strategies and product innovation are
used to determine the intrinsic value of investment tools. Fundamental analysis stands on the
assumption that each security (and market in total) has an intrinsic or integer value based on
investors estimates. Such value is a function of companys fundamental variables combined to
create expected return and its related risk. One can estimate intrinsic value by evaluating
fundamental variables of security value determinants. Then, estimated intrinsic value can be
compared to security current price in the market.

Fundamental analysis is performed on historical and present data but with the goal of making
financial forecasts. There are several possible objectives:
To conduct a company stock valuation and predict its probable price evolution,
To make a projection on its business performance,
To evaluate its management and make internal business decisions,
To calculate its credit risk.

When analyzing a stock, future contract or currency using fundamental analysis there are two
basic approaches one can use; Bottom up analysis and Top down analysis. The term is used to
distinguish such analysis from other types of investment analysis, such as Quantitative analysis
and Technical analysis.
TOP DOWN AND BOTTOM UP APPROACH
In Topdown analysis, economy/market, industry and firm are analyzed respectively. Economy
and market for securities are analyzed to see whether it is the right time to allocate additional
sums to stocks or not. Then, industries and sections are analyzed to decide which one has the
best outlook in future. Finally, company is analyzed.
In Bottom-up approach, investors focus on firms pillars or foundations directly. Analyzing such
data as firms products, competitive status and financial situation lead to estimate potential
profits and, ultimately, its value in the market. In this approach, it is emphasized on finding
companies with long term growth perspective and on right estimations on profit.



Figure 1: Top-Down & Bottom-up analysis in Fundamental analysis

Two analytical models:
When the objective of the analysis is to determine what stock to buy and at what price, there are
two basic methodologies.
1. Fundamental Analysis: Means that market may misprice a security in the short run but
the correct price will eventually be reached. Profits can be made by purchasing the
mispriced security and then waiting for the market to recognize its mistake and re-price
the security. Analyzing fundamentals such as earnings, cash flow and assets, is useful in
determining buyout and liquidation value of a company. Growth model can be made to
gauge potential accumulation in the worth of the company. In short, Fundamental
analysts will try to figure out what a stock is really worth versus what it is being traded
at.
2. Technical Analysis: Technical analysis says nothing of a companys finances; it
attempts to get inside of the investor. It maintains that all the information is reflected
already in the stock price. It does not care what the value of a stock is. Technical
analysts will always attempt to gauge the current emotional state of buyers to forecast if
further buying or selling is likely. Their price predictions are only extrapolations from
historic price patterns.
The choice of stock analysis is determined by the investor's belief in the different paradigms for
"how the stock market works". For example, many fundamental investors use technical for
deciding entry and exit points. Many technical investors use fundamentals to limit their universe
of possible stock to good companies.
E-I-C Approach
The approach to fundamental analysis often referred to E-I-C approach. The E-I-C denotes the
three parts of the fundamental analysis. They are:
1. Economic Analysis
2. Industry Analysis
3. Company Analysis

Economic Analysis
Economic analysis is the analysis of forces operating the overall economy of a country. It is a
process whereby strengths and weaknesses of an economy are analyzed and is important in order
to understand exact condition of an economy. At economy level, fundamental analysts focus on
economic indicators and reports to access how well the economy is doing and how well the
economy is going to do in the future. These indicators include GDP, retail sales, inflation and
unemployment figures.
Industry Analysis
Industry analysis involves understanding industry supply and demand forces, competition and
industry regulation. Often enough, stocks are not lone rangers. They tend to move in groups!
Factors such as overall growth rate, market size and importance to the economy are considered
when analyzing industry groups.
Company Analysis
Company analysis involves the examination of the balance sheet, the income statement,
management, the companys debt and cash flow. Financial and annual reports are usually being
used as research material when forecasting profits of the company stocks. This will help in
getting a basic understanding of the pricing in the stock market.



Figure 2: E-I-C Approach

Use by different portfolio styles:
Investors may use fundamental analysis within different portfolio management system.
Buy and hold investors believe that latching onto good businesses allows the
investor's asset to grow with the business. Fundamental analysis lets them find 'good'
companies, so they lower their risk and probability of wipe-out.
Managers may use fundamental analysis to correctly value 'good' and 'bad'
companies. Eventually 'bad' companies' stock goes up and down, creating
opportunities for profits.
Managers may also consider the economic cycle in determining whether conditions
are 'right' to buy fundamentally suitable companies.
Contrarian investors distinguish "in the short run, the market is a voting machine, not
a weighing machine".
[2]
Fundamental analysis allows you to make your own decision
on value, and ignore the market
Value investors restrict their attention to under-valued companies, believing that 'it's
hard to fall out of a ditch'. The value comes from fundamental analysis.
Managers may use fundamental analysis to determine future growth rates for buying
high priced growth stocks.
Managers may also include fundamental factors along with technical factors into
computer models.

Financial Ratios for analysis
Financial analysts use financial ratios to compare the strengths and weaknesses in various
companies. If shares in a company are traded in a financial market, the market price of the shares
is used in certain financial ratios.
Main types of financial ratios are:
Profitability ratios
Profitability ratios measure the company's use of its assets and control of its expenses to generate
an acceptable rate of return. Some profitability ratios are:
Gross margin
Operating margin
Profit margin
ROE
ROA
Efficiency ratio
Cash flow return on investment
Basic earning power ratio Etc.
Liquidity ratios
Liquidity ratios measure the availability of cash to pay debt. Some liquidity ratios are:
Current ratio
Quick ratio
Cash ratio
Operation cash flow ratio Etc.
Activity ratios (Efficiency ratios)
Activity ratios measure the effectiveness of the firms use of resources. Some activity ratios are:
DSO Ratio
Asset turnover
Stock turnover
Receivables turnover ratio
Cash conversion cycle
Payable conversion period Etc.
Debt ratios (leveraging ratios)
Debt ratios quantify the firm's ability to repay long-term debt. Debt ratios measure financial
leverage. Some debt ratios are:
Debt ratio
Debt to equity ratio
Time interest earn ratio Etc.
Market ratios
Market ratios measure investor response to owning a company's stock and also the cost of
issuing stock. Some important market ratios are:
EPS ratio
Payout ratio
P/E ratio
Dividend yield Etc.

Capital budgeting ratios
Many formal methods are used in capital budgeting, including the techniques such as:
NPV
Profitability index
Internal rate of return
Equivalent annuity Etc.
By analyzing these ratios one can take correct decision about a companys position. Financial
ratios quantify many aspects of a business and are an integral part of the financial statement
analysis. Ratios can also help managers make decisions about investments or projects that the
company is considering to take, such as acquisitions, or expansion.
Fundamental Trading
Trading on fundamentals is associated with a buy and hold strategy (long-term) rather than a
daily/weekly (short term) strategy of investing. There are, however, specific instances in which
trading on fundamentals can generate some nice profits in a short period.
A good example of a person with successful fundamental trading and investing is Warren Buffet.
He has managed to achieve exceptional returns by analyzing company/industry/economy
fundamentals and investing in companies he felt were undervalued.
Is Fundamental analysis a traditional way in investing stocks?

This kind of analysis does the comprehensive steps in analyzing, since it does a proper
evaluation on firm financial statement and also the qualitative factors associate with the firm.
However, there is criticism on fundamental analysis which assuming that doing fundamental
analysis is only wasting time. This criticism emerges from the technical analysts and the believer
of efficient market hypothesis. Technical analysis basically use by the analyst for the security
analysis base on the current price and volume. They tend to use either candlestick chart or line
chart and several indicators, in order to predict the momentum of the stock price and ignore the
fundamental. Technical analysts also assume that stock price implies all news and latest
information on the company. While the theory of efficient market hypothesis is different between
both fundamental and technical analysis. This theory state that it is impossible to generate market
return in long term, since all stock price is efficiently been priced by the market. So, it is
impossible to get any high return derived by fundamental or technical analysis.

Criticisms
Economists such as Burton Malkiel suggest that neither Fundamental analysis nor Technical
analysis is useful in outperforming the markets.

Bottom Line
After a brief explanation on how fundamental analysis is work, we know that without this kind
of analysis, such investor could not predict the movement of the price for such stock. An analysis
should be done in proper manner, starting with the uses of either top down approach or bottom
up approach. This is the basic rule of analysis in fundamental. When investors abandoned
fundamental analysis before make any investment, they will see the different view of such
company. For an example, financial ratio like Price earnings ratio will tell the investor whether
current stocks price is overvalue or undervalue. With this ratio also investor can predict the firm
growth and how far the price cans roses. But, when investors only depend heavily on technical
analysis, all that they will get is sentiment. No brief information how far the stocks price can
increase and the exact figure to evaluate the value of the stocks.
As conclusion, fundamental analysis should be used as the main sources or method in investing
in stocks, because it can provide all the information needed about the firm and also it value of
stocks.