Is fundamental analysis redundant Essay

IntroductionShortly subsequently the bank line securities industry crash in 1929, as the first survey of fiscal experts in the Great Wall, Benjamin Graham and David Dodd firstly mentioned the pattern in a defend called security summary Based on public info that intelligent investors are able to analyse securities and congeal whether the current correspond of transports and bonds is over or below their intrinsic value. The comminuted thinking and strong logic declare this theory become the inverteb compute foot of to the highest degree all investments theories in Wall Street. Warren Buffett, John Neff, whoreson Lynch and other famous investors become thebest practitioners in natural analysis. This experiment will firstly introduce the related theories of fundamental analysis. Secondly, the essay will explain assuage exchange period object slighton to equity valuation and the qualitative and quantitative factors of fundamental analysis. Thirdly, choosing a p articular confederacy analyses the alliances in the midst of the leading pecuniary balances and its simple eye legal injury. Finally, indicating why financial symmetrys and free cash flow model bottomnot explain Berkshire Hathaway coope dimensionns product line turn uplayy changed during international financial crisis.Theory Aasuumption & MetholodyTheoryFundamental analysis which is ground on analyzing the intrinsic value of securities, focuses on factors affecting the melodic line footing and its trend and lets investors determine what type of securities they choose to buy and when to buy. (Lee and Swaminathan 1999, 8 )The introductory assumption of fundamental analysis is that value investors believe that the grocery impairment is determined by its intrinsic value and the derivation damage can reflect its intrinsic value in the prospicient term.Cash flow modelFundamental analysts use cash flow model, dividend model to almost label a companionships intr insic value. They assume that the stock set of the intrinsic value is its bear witness value of the stream of evaluate cash flows and the selected reference determine are establish on generating the cash flow selective information. For example, using free cash flow model to poster intrinsic value, investors firstly assume the spy participation can attach at constant respect and then choose the reference value based on a constant growth rate (g)to estimate free cash flow the next 10 years. Secondly, they lead the present value of the 10-year cash flow based on the constantly discounted rate (k). Secondly, they estimate the terminal value P10=free cash flow*(1+g)/(k-g) and calculate its present value. Thirdly, they get the present value of the troupe and calculate pre- portion out value equity value/numbers of shares. Rational investors can yield well-informed investment decisions according to the relationship amidst commercialise impairment and intrinsic value.Qualita tive factorsOn the attach to level, fundamental analysis cerebrate on two factors qualitative and quantitative. Qualitative and quantitative analyses beget a dialectical relationship. Both analyses should join together to analysis and inspect on a particular go with. Although qualitative analysis is harbour for physical areas, with the example to tackle non-financial information, it can be widely useful in business concern and finance fields.(kesh and Raja 2005, 167) The qualitative analysis of the companionship level is pertain with products and work, competitive advantage, way cogency, corporate culture.Advanced products can get emergence cash inflows and improve company value (Carter and Demissew 2008, 63) because booming demand for products and services can lead to a high reinvestment rate of the company, this creates additional wealth.( madden 2007, 125) Competitive advantage can includes producing capacity and the efficiency of a companys design and cost control ling better than the industrys competitors. Generating a competitive advantage for a company will creates stake fuddleer value. (Vilanova, Lozano and Arenas 2009, 63) The cash advance of management efficiency can lower operating costs and company culture can enhance corporate image, leading to improvement of company value.Quantitative factorsThe quantitative factors in fundamental analysis are based on a deep understanding of financial reports which is the process of identifying opportunities and threats from the company, so investors must be concerned with the balance sheet, cash flow program line and income statement analysis. mo give the axeary statements consist of all distinguished historical information about the companys operation management during a precise time period (quarterly, yearbookly). all(prenominal) these information provide an overview of a companys business activities and can help managers assess the companys wellbeing. (Dayanandan 2010, 116)Financial stat ementDifferent users are interested in diametric areas of the financial statements. For example, investors and equity holders are concerned with anticipate earnings and dividends of the observed companies. Companys executives usually focus on the companys capacity. Therefore, based on historical reports, different users can get outlay(predicate) information about what they concentrate on. Financial statement analysis includes selected data from financial statements to predict the companys financial health.( Hagos and Pal 2010, 441) Applying these data from financial reports, much(prenominal) as profitability ratio, liquid ratio, management efficiency ratio, debt ratio, market performance ratio analyses year by year to determine whether to buy or sell observed companies.Based on analyzing financial statements, financial analysts are able to use profitability ratio, including gross margin, roe to indicate how efficiently revenue is generated. The liquidity ratio such as current ratio, net working capital can be used to prove the theaters ability to generate sufficient liquidity when needed and to meet misfortunate term obligations. For example, current ratio is an indicant as a rate of current assets to current liabilities. It measures the liquidity lieu of a company. With a higher current ratio over time, this company will be able to meet its current obligations and experience little(prenominal) financial take chances.( Zaki, Bah and Rao 2011, 315) Table1 Sourced by BerkshireYear roeTotal asset overturnDebt/equityP/EP/Bclosed outlay20030.1050.5881.3212.71.34$8428020040.0850.3941.2018.81.6$8790020050.0930.4121.1615.51.45$8862020060.1020.3971.2712.51.27$109990Table 1 above shows the some figures provided by Berkshire corporations annual report from 2003 to 2006. During this period, the stock toll has a real increase from $67600 in Jan 2rd, 2003 to $109990 in Dec 1st, 2006. And from 2003 to 2006, Berkshire Hathaway Incs net worth is $13.6billion, $ 8.3billion, $5.6billion and 16.9billion respectively.Graph1 Berkshire Hathaway(BRK) Incs stock price among 2003 and 2006Sourced by chawbacon financeThe increase of Net worth can indicate the stock prices change during this period. The accumulate in net worth during 2003 was $13.6billion, which increase the per-share book value of its stock by 21% from $41727 to $50498. Becauseof good quarterly reports and an annual report, the stock price reflected the companys performance, advance from $67600 to $89490. However, between 2004 and 2005, the turn a profit in net worth increase $8.3billion and $5.6billion. Although in 2004 Berkshires book-value gain of 10.5% fierce short of the indexs 10.9% return, the net worth fell from $13.6billion to $8.3billion, leading to fluctuation of the stock price during 2004. In 2005, the net worth fell to $5.6 billion because hurricane caused loss worth of $34billion. And in the stock market, the price fluctuated and even slightly increase. However, the price reflected the companys performance.As a multi-business company, its main business-insurance company called GEICO improved its management efficiency at nearly 32% and warranty numbers increased by 26%. On the other hand, insurance float of BRKs insurance company increased from 46 billion to 49 billion. Due to the capital cost rate of mostly 0% and improving competitiveness, its stock price rose sharply.Financial ratios (price to book ratio and earnings per share ratio) measure share price compared to earnings, book value per share and indicate whether the market overvalues, undervalues and appropriately values the firm shares. Managers use to assess investors perceptions of future prospects. more or less investors invest in stock market based on analyzing financial statements.Table2Table2 shows mainly the relationship between the book value and stock price. Financial analysts are volition to use book value to measure the stock price. From the table 2 above, the book value of the Berkshire Hathaway increases from $14426 in 1995to $70281 in 2006 and the companys stock movements, rising from $31900 in 1995 to $110050 in 2006. In addition to particular years, these two charts reflect clearly whether a short term or a long term, the trend of the book value and stock price is nigh the same. In the long term, the growth rate of the net worth is a useful indicator to justify intrinsic value. From 1995 to 2006, the net worth of Berkshire Hathawaysnet worth increased from $5.3billion to $16.9billion, to a greater extent than 3.18 times growth during the period. song price had increased 3.44 times with book value 4.87 times. Although 1n 1999, the net worth fell to 0.358billion, in the long term, this company still had a significant increase in its stock market performance.Analysts also can apply activity ratios such as total asset derangement ratio and average payment ratio period to measure management forte in managing its assets and to determine whether the investment in particular asset categories is in addition high or too low and also find out the efficiency or speed in converting accounts to sales or cash. (Dayanandan 2010, 114)Debt ratios such as debt to equity ratio and debt ratio can indicate financial leverage and the apparent financial risk assumed by the firms equity holders.ApplicationDow JonesGraph2 Dow Jones industrial indexSourced by yahoo financeGraph2 shows the change of Dow Jones industrial index before, during and after global financial crisis. The global financial crisis started in 2007 because the burst of housing bubble caused credence crisis especially in the debt markets.( McCarthy, Solomonand Mihalekl 2012, 1277 ) the stock market highly violated between 2007 and 2009. For example, in United States, the stock market increased to the peak in October 2007 with the Dow Jones Industrial Average about 14,000. After that duration, the Dow Jones dropped sharply from 12,000 in swaggering 2008 to 6,600 in March 20 09. After 2009, there is significant increase until now, rising to 14,929.Company- Berkshire HatchawaysBerkshires core business for insurance business includes the property hap reinsurance and special class insurance company. For the past 25 years, this company has more and more strong capital and little debt, for shareholders to create the value of more than 25% growth on average everyyear. Table 3 shows analysis ratios and stock price from 2006 to 2012. Table3YearROETotal asset turnoverDebt/equityP/EP/Bclosed expense20060.1020.401.2712.51.27$10999020070.1090.431.2413.81.51$14160020080.0460.401.4138.161.71$9660020090.0590.381.1918.11.11$9920020100.080.371.2914.91.24$12045020110.060.371.32191.18$11475520120.0770.381.23141.1$133000Sourced by BerkshireGraph3 Berkshires stock price between 2006 and 2012Sourced by yahoo financeThe gain in net worth during 2006 was $13.6billion, which increased the per-share book value of its stock by 18.4% to $109990. In 2007, the net worth is 12.3bil lion, which increased the per-share book value of its stock by 11% to $141600. However, in 2008, the stock price fell to $96600, and then there is an increase trend from 2009 to 2012.Total assets turnover ratioTotal assets turnover ratio measures the management efficiency of the firm in managing its total assets to generate sales. A high ratio suggests greater efficiency. Figures shown in table3, the total assets turnover ratio during global crisis had slight change between 0.37 and 0.40. However, the stock price changed sharply, so the stock price can not reflect the stability of this ratio. ROE indicates the rate of return realized by a firms shareholders on their investments and uses as an indicator for the companys operation.Return on equity (ROE)Return on equity (ROE) is the best indicator to key how much money a company is making for its investors and measurement of the companys operations. (Dayanandan 2010, 117) However, ROE is also sensitive to leverage. Assuming that proce eds from debt support can be invested at a return greater than the get rate, ROE will increase with greater amounts of leverage. From 2007 to 2008, the debt to equity ratio increased by 13.7%, from 1.24 to 1.41. However, ROE rate fell sharply from 10.9% to 4.6%. Although ROE react to debt change, Berkshires fundamental did not change in 2008. Most of Berkshires business is affected by the economic significant downward in 2009. However, its manufacturing services and retail generated a lot of cash flow and move to consolidate their market competitive advantage. Berkshires two most important businesses business insurance and utilities also had a good growth rate. These businesses produced a large amount of business profits in 2008.P/E ratioP/E ratio is a common come used by security analysts. In practice, investors usually use expected P/E ratio for the following year and analyse whether the stock price is overvalued or undervalued on the basis. P/E ratio indicates that a stock o f its P/E rate over 30 is more likely to be overpriced. The P/E ratio in 2007 and 2008 is 13.8 and 38 respectively and the stock price during the period time of 2007 and 2008 is $141600 and $96600. The change of stock price is overreact to the pre-share earnings.P/B ratioP/B ratio gives some idea of whether an investor is paying too much for what would be left if the company went bankrupt immediately. From 2006 to 2009, P/B ratio increased or decreased had no direct correspondence with the stock price. However, to most companies, the book value is always lower than the stock price. Because most companies have intangible assets such as brand name, specialized skillsproduct set power. These factors can not reflect in the balance sheet, but the long term trend of the market value is similar with book value. It seems that when P/B ratio increases, the gap between book value and stock price increases. On the other hand, the gap shows investors are willing to hold the stock due to its in tangible assets.Cash flow modelAll these financial ratios cannot explain what happened in 2008 and using cash flow model to estimate the stock price also cannot explain this situation. Because investors assume the company can increase at constant rate. Although they use long-term gross domestic product growth rate to reduce the risk of assessing value, this growth rate cannot explain and predict what happened during the investing period. They also use CAPM to measure discounted rate granted by the risk-free interest rate plus a risk premium. The formula is ki=Rf+(Rm-Rf)i. However, sometimes cannot estimate risk between the market and stock. For example, a companys market value increases from 10billion t0 20billion is less than market value of the company from 10billion to 3billion. If the company still operate well, from the market side, the risk of buying a company of the market value of 20billion is less than buying the same company of its market value of 3billion.ConclusionThere fore, during global financial crisis, fundamental analysis was useless. It is clear that during some periods the stock price is overvalued or undervalued significantly from its intrinsic value, leading to highly volatility of market price. Any market volatility is considered as irrational performances, so these market valuations caused by behavioral finance which do not have impacts on the companys assets valuations andoperations. (Adams, Armitage and FitzGerald 2012, 157).In the long term, the trend of the stock price is similar to the trend of its intrinsic value. On the other hand, in the short term, market price is influenced and fluctuated by political, economic, psychological factors, so market price is always undervalued or overvalued, but it is fluctuating around the intrinsic value. Some research show that sometimes earnings information cannot react to the stock market simultaneously and all the public financial information define a gradual influence on the stock market fo r a while. During global financial crisis, the stock price sharply fluctuated because of financial behavior. Debt crisis caused by housing loan had a significant impact on muckles confidence. Traders low confidence let them make decisions irrationally.Reference list1. Lee, C.M.C. and Swaminathan, B. 1999. Valuing the Dow A bottom-up approach. Financial Analysts Journal 55 (5) 4-23.2. Kesh, Someswar. and Raja, M. K. 2005. Development of a qualitative reasoning model for financial forecasting. schooling care & Computer Security 13 (2) 167-179.3. Carter, T. and Demissew, D.E. 2008. Value innovation management and discounted cash flow. Management Decision 46(1) 58-76.4. Madden, B.J. 2007. Guidepost to Wealth Creation Value-Relevant baseball swing Records. Journal of Applied Finance 17 (2) 119-130.5. Vilanova, M., Lozano, J.M. and Arenas, D. 2009. Exploring the Nature of the Relationship amidst CSR and Competitiveness.Journal of Business Ethics 87 57-69.6. Dayanandan, R. 2010. 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