Fundamental Analysis
This type of approach consists in selecting stocks based on information regarding the company’s financials, field of activity, price setting relative to various reference points concerning the company and the overall market.
It is a useful tool for medium and long-term stock investing (1 year minimum). Those using this type of analysis have different return and liquidity objectives, prevailingly employing certain criteria.
Selecting Stocks based on Fundamental Analysis
Value Investing criterion – some of the long-term investors are concerned with determining the value of the company wherein they invest their money, seeking to buy the stock at a higher discount compared to the value computed by them based on several information available on the market regarding that company.
In other words, the question raised is how much would the company’s net assets be worth if they were sold? An approximate answer might be provided by assessing the asset elements (plots of land, fixed assets, current assets) at a fair market value, then adding the liquid assets available and deducting debts.
Regarding the Romanian market, there have been and still are situations when some companies’ market capitalization is inferior to their net assets mainly because of an inefficient exploitation of the latter. Investors who buy stocks based on Value Investing criteria believe that a particular enterprise might become lucrative by changing the shareholding structure, improving the economic environment or by undergoing other major changes, point when the company will be quoted at its intrinsic value
Growth Stocks criterion – it is used by investors preoccupied with identifying companies within growth industries. Mainly, this criterion monitors the increase in sales and profit, determining the growth rates in real terms. These might be extrapolated in the future as well, however, it is advisable to identify potential economic or legislative risk factors that might affect this evolution. The quality of the company’s business should also be considered, along with the existence of some competitive advantages against other similar companies. In general, growth stocks do not pay dividends, the investor making profit almost exclusively from the price differential. Such companies are the riskiest because of the lack of dividends that might have been a reference point regarding the price, as well as the uncertainty effect regarding the company’s evolution within the forecasted growth parameters.
Strictly speaking, we could state that the investor who mainly employs the value investing criterion is seeking average or good enterprises at low prices, whereas the investor mainly using the growth stock criterion is looking for good and great enterprises at low or average prices. In fact, both these approaches are interrelated.
Income Stocks criterion – dividend yield in the case of stocks. Investors prefer such stocks due to the need of having a certain certitude regarding the return on investment. High dividend yield stocks are recommended, belonging to reliable and mature companies from a financial standpoint. Generally, the investment horizon of the holders of such stocks is of 1 year. There are also dividend investors who hold a stock for several years provided those dividends have a certain growth rate.
In practice, we come across combinations of the aforementioned approaches- one of them being the Growth at a Reasonable Price criterion. These stocks belong to some growth companies, the price being considered as undervalued by investors. The information used is prevailingly quantitative-based, i.e. indicators such as growth rates and PER.
Another way of assessing an investment in a company is by employing the qualitative analysis. This method gives priority to the return, managerial competence and intangible assets such as the “good will”. Investors considering such criteria look beyond the quantitative elements derived based on financial statements, assessing the value that is not immediately reflected in the book value: market position, human resources and management quality. This type of analysis does not entail the mere extrapolation in the future of some historical indicators, but reckons on their improvement due to the increase in enterprise quality; this is the reason why investors would be willing to pay a premium above the average price considered at a certain moment.
A number of counterarguments were brought to the fundamental analysis, the strongest one being that it is based on publicly known information without benefiting from a major advantage against the other market participants. Nevertheless, on several capital markets has been proven the fact that there are always a number of underpriced companies that may bring higher capital gains than the market’s average throughout several years.
Therefore, the use of fundamental analysis criteria depends on the investor’s objectives of return on equity and the risk he is willing to take, including the frequency with which he/she wishes to turnover his/her capital.
Deciding to sell based on fundamental analysis:
Simplified, a stock should be sold based on fundamental analysis criteria, when the initial answer to the question: “Why did I buy the share?” loses its validity. The following circumstances might also be sound reasons to sell the stock:
- A news item about the company or the corresponding industry that changes the initial expectations (little likelihood of achieving the financial indicators within the initially estimated levels, a possible repercussion of legislative or fiscal change in the corresponding field of activity etc.)
- An overvaluation of the stock’s price, above the level justified by financial performances; ceilings might be set given by valuation ratios such as PER, Price/Book Value, Price/Sales, beyond which a stock can be considered overpriced.
- the overvaluation might also occur through comparison with other companies in the industry or with the market average.
