Fundamental analysis is the examination of the underlying forces that affect the well

being of the economy, industry groups, and companies. As with most analysis, the goal
is to derive a forecast and profit from future price movements. At the company level,
fundamental analysis may involve examination of financial data, management, business
concept and competition. At the industry level, there might be an examination of supply
and demand forces for the products offered. For the national economy, fundamental
analysis might focus on economic data to assess the present and future growth of the
economy. To forecast future stock prices, fundamental analysis combines economic,
industry, and company analysis to derive a stock's current fair value and forecast future
value. If fair value is not equal to the current stock price, fundamental analysts believe
that the stock is either over or under valued and the market price will ultimately gravitate
towards fair value. Fundamentalists do not heed the advice of the random walkers and
believe that markets are weak-form efficient. By believing that prices do not accurately
reflect all available information, fundamental analysts look to capitalize on perceived
price discrepancies.

General Steps to Fundamental Evaluation

Even though there is no one clear-cut method, a breakdown is presented below in the
order an investor might proceed. This method employs a top-down approach that starts
with the overall economy and then works down from industry groups to specific
companies. As part of the analysis process, it is important to remember that all
information is relative. Industry groups are compared against other industry groups and
companies against other companies. Usually, companies are compared with others in
the same group. For example, a telecom operator (Verizon) would be compared to
another telecom operator (SBC Corp), not to an oil company (ChevronTexaco).

Economic Forecast
First and foremost in a top-down approach would be an overall evaluation of the general
economy. The economy is like the tide and the various industry groups and individual
companies are like boats. When the economy expands, most industry groups and
companies benefit and grow. When the economy declines, most sectors and companies
usually suffer. Many economists link economic expansion and contraction to the level of
interest rates. Interest rates are seen as a leading indicator for the stock market as well.
Below is a chart of the S&P 500 and the yield on the 10-year note over the last 30
years. Although not exact, a correlation between stock prices and interest rates can be
seen. Once a scenario for the overall economy has been developed, an investor can
break down the economy into its various industry groups.
Group Selection
If the prognosis is for an expanding economy, then certain groups are likely to benefit
more than others. An investor can narrow the field to those groups that are best suited
to benefit from the current or future economic environment. If most companies are
expected to benefit from an expansion, then risk in equities would be relatively low and
an aggressive growth-oriented strategy might be advisable. A growth strategy might
involve the purchase of technology, biotech, semiconductor and cyclical stocks. If the
economy is forecast to contract, an investor may opt for a more conservative strategy
and seek out stable income-oriented companies. A defensive strategy might involve the
purchase of consumer staples, utilities and energy-related stocks.

To assess a industry group's potential, an investor would want to consider the overall
growth rate, market size, and importance to the economy. While the individual company
is still important, its industry group is likely to exert just as much, or more, influence on
the stock price. When stocks move, they usually move as groups; there are very few
lone guns out there. Many times it is more important to be in the right industry than in
the right stock! The chart below shows that relative performance of 5 sectors over a 7-
month time frame. As the chart illustrates, being in the right sector can make all the
difference.

Narrow Within the Group

Once the industry group is chosen, an investor would need to narrow the list of
companies before proceeding to a more detailed analysis. Investors are usually
interested in finding the leaders and the innovators within a group. The first task is to
identify the current business and competitive environment within a group as well as the
future trends. How do the companies rank according to market share, product position
and competitive advantage? Who is the current leader and how will changes within the
sector affect the current balance of power? What are the barriers to entry? Success
depends on an edge, be it marketing, technology, market share or innovation. A
comparative analysis of the competition within a sector will help identify those
companies with an edge, and those most likely to keep it.

Company Analysis
With a shortlist of companies, an investor might analyze the resources and capabilities
within each company to identify those companies that are capable of creating and
maintaining a competitive advantage. The analysis could focus on selecting companies
with a sensible business plan, solid management and sound financials.

Business Plan
The business plan, model or concept forms the bedrock upon which all else is built. If
the plan, model or concepts stink, there is little hope for the business. For a new
business, the questions may be these: Does its business make sense? Is it feasible? Is
there a market? Can a profit be made? For an established business, the questions may
be: Is the company's direction clearly defined? Is the company a leader in the market?
Can the company maintain leadership?

Management
In order to execute a business plan, a company requires top-quality management.
Investors might look at management to assess their capabilities, strengths and
weaknesses. Even the best-laid plans in the most dynamic industries can go to waste
with bad management (AMD in semiconductors). Alternatively, even strong
management can make for extraordinary success in a mature industry (Alcoa in
aluminum). Some of the questions to ask might include: How talented is the
management team? Do they have a track record? How long have they worked
together? Can management deliver on its promises? If management is a problem, it is
sometimes best to move on.

Financial Analysis
The final step to this analysis process would be to take apart the financial statements
and come up with a means of valuation. Below is a list of potential inputs into a financial
analysis.

Accounts Payable Good Will

Accounts Receivable Gross Profit Margin
Acid Ratio Growth
Amortization Industry
Assets - Current Interest Cover
Assets - Fixed International
Book Value Investment
Brand Liabilities - Current
Business Cycle Liabilities - Long-term
Business Idea Management
Business Model Market Growth
Business Plan Market Share
Capital Expenses Net Profit Margin
Cash Flow Pageview Growth
Cash on hand Pageviews
Current Ratio Patents
Customer Relationships Price/Book Value
Days Payable Price/Earnings
Days Receivable PEG
Debt Price/Sales
Debt Structure Product
 Debt:Equity Ratio Product Placement
Depreciation Regulations
Derivatives-Hedging R&D
Discounted Cash Flow Revenues
Dividend Sector
Dividend Cover Stock Options
Earnings Strategy
EBITDA Subscriber Growth
Economic Growth Subscribers
Equity Supplier Relationships
Equity Risk Premium Taxes
Expenses Trademarks
Weighted Average Cost of Capital

The list can seem quite long and intimidating. However, after a while, an investor will
learn what works best and develop a set of preferred analysis techniques. There are
many different valuation metrics and much depends on the industry and stage of the
economic cycle. A complete financial model can be built to forecast future revenues,
expenses and profits or an investor can rely on the forecast of other analysts and apply
various multiples to arrive at a valuation. Some of the more popular ratios are found by
dividing the stock price by a key value driver.

Ratio
Company Type
Price/Book Value
Oil
Price/Earnings
Retail
Price/Earnings/Growth
Networking
Price/Sales
B2B
Price/Subscribers
ISP or cable company
Price/Lines
Telecom
Price/Page views
Web site Biotech
Price/Promises

This methodology assumes that a company will sell at a specific multiple of its earnings,
revenues or growth. An investor may rank companies based on these valuation ratios.
Those at the high end may be considered overvalued, while those at the low end may
constitute relatively good value.

Putting it All Together

After all is said and done, an investor will be left with a handful of companies that stand
out from the pack. Over the course of the analysis process, an understanding will
develop of which companies stand out as potential leaders and innovators. In addition,
other companies would be considered laggards and unpredictable. The final step of the
fundamental analysis process is to synthesize all data, analysis and understanding into
actual picks.

Strengths of Fundamental Analysis

Long-term Trends
Fundamental analysis is good for long-term investments based on long-term trends,
very long-term. The ability to identify and predict long-term economic, demographic,
technological or consumer trends can benefit patient investors who pick the right
industry groups or companies.

Value Spotting
Sound fundamental analysis will help identify companies that represent a good value.
Some of the most legendary investors think long-term and value. Graham and Dodd,
Warren Buffett and John Neff are seen as the champions of value investing.
Fundamental analysis can help uncover companies with valuable assets, a strong
balance sheet, stable earnings, and staying power.

Business Acumen
One of the most obvious, but less tangible, rewards of fundamental analysis is the
development of a thorough understanding of the business. After such painstaking
research and analysis, an investor will be familiar with the key revenue and profit drivers
behind a company. Earnings and earnings expectations can be potent drivers of equity
prices. Even some technicians will agree to that. A good understanding can help
investors avoid companies that are prone to shortfalls and identify those that continue to
deliver. In addition to understanding the business, fundamental analysis allows
investors to develop an understanding of the key value drivers and companies within an
industry. A stock's price is heavily influenced by its industry group. By studying these
groups, investors can better position themselves to identify opportunities that are high-
risk (tech), low-risk (utilities), growth oriented (computer), value driven (oil), non-cyclical
(consumer staples), cyclical (transportation) or income-oriented (high yield).

Knowing Who's Who

Stocks move as a group. By understanding a company's business, investors can better
position themselves to categorize stocks within their relevant industry group. Business
can change rapidly and with it the revenue mix of a company. This happened to many of
the pure Internet retailers, which were not really Internet companies, but plain retailers.
Knowing a company's business and being able to place it in a group can make a huge
difference in relative valuations.

Weaknesses of Fundamental Analysis

Time Constraints
Fundamental analysis may offer excellent insights, but it can be extraordinarily time-
consuming. Time-consuming models often produce valuations that are contradictory to
the current price prevailing on Wall Street. When this happens, the analyst basically
claims that the whole street has got it wrong. This is not to say that there are not
misunderstood companies out there, but it is quite brash to imply that the market price,
and hence Wall Street, is wrong.

Industry/Company Specific
Valuation techniques vary depending on the industry group and specifics of each
company. For this reason, a different technique and model is required for different
industries and different companies. This can get quite time-consuming, which can limit
the amount of research that can be performed. A subscription-based model may work
great for an Internet Service Provider (ISP), but is not likely to be the best model to
value an oil company.

Subjectivity
Fair value is based on assumptions. Any changes to growth or multiplier assumptions
can greatly alter the ultimate valuation. Fundamental analysts are generally aware of
this and use sensitivity analysis to present a base-case valuation, an average-case
valuation and a worst-case valuation. However, even on a worst-case valuation, most
models are almost always bullish, the only question is how much so. The chart below
shows how stubbornly bullish many fundamental analysts can be.
Analyst Bias
The majority of the information that goes into the analysis comes from the company
itself. Companies employ investor relations managers specifically to handle the analyst
community and release information. As Mark Twain said, "there are lies, damn lies, and
statistics." When it comes to massaging the data or spinning the announcement, CFOs
and investor relations managers are professionals. Only buy-side analysts tend to
venture past the company statistics. Buy-side analysts work for mutual funds and
money managers. They read the reports written by the sell-side analysts who work for
the big brokers (CIBC, Merrill Lynch, Robertson Stephens, CS First Boston, Paine
Weber, DLJ to name a few). These brokers are also involved in underwriting and
investment banking for the companies. Even though there are restrictions in place to
prevent a conflict of interest, brokers have an ongoing relationship with the company
under analysis. When reading these reports, it is important to take into consideration
any biases a sell-side analyst may have. The buy-side analyst, on the other hand, is
analyzing the company purely from an investment standpoint for a portfolio manager. If
there is a relationship with the company, it is usually on different terms. In some cases
this may be as a large shareholder.

Definition of Fair Value

When market valuations extend beyond historical norms, there is pressure to adjust
growth and multiplier assumptions to compensate. If Wall Street values a stock at 50
times earnings and the current assumption is 30 times, the analyst would be pressured
to revise this assumption higher. There is an old Wall Street adage: the value of any
asset (stock) is only what someone is willing to pay for it (current price). Just as stock
prices fluctuate, so too do growth and multiplier assumptions. Are we to believe Wall
Street and the stock price or the analyst and market assumptions?

It used to be that free cash flow or earnings were used with a multiplier to arrive at a fair
value. In 1999, the S&P 500 typically sold for 28 times free cash flow. However,
because so many companies were and are losing money, it has become popular to
value a business as a multiple of its revenues. This would seem to be OK, except that
the multiple was higher than the PE of many stocks! Some companies were considered
bargains at 30 times revenues.

Conclusions
Fundamental analysis can be valuable, but it should be approached with caution. If you
are reading research written by a sell-side analyst, it is important to be familiar with the
analyst behind the report. We all have personal biases, and every analyst has some
sort of bias. There is nothing wrong with this, and the research can still be of great
value. Learn what the ratings mean and the track record of an analyst before jumping
off the deep end. Corporate statements and press releases offer good information, but
they should be read with a healthy degree of skepticism to separate the facts from the
spin. Press releases don't happen by accident; they are an important PR tool for
companies. Investors should become skilled readers to weed out the important
information and ignore the hype.