There are 4 basic steps taken when applying fundamental analysis to a company, and these involve:-
- Place the company in perspective versus the economy as a whole.
- Place the company in perspective versus the industry sector it belongs to.
- Evaluate the condition of the company.
- Combine these results to guage the value of the company’s stock.
The Strength of the Economy as a whole
Obviously, in boom times, prices tend to be higher than in depressions. Therefore economists examine the economy as a whole as a starting point to the analysis – what is the environment in which ALL stocks exist? Is there rampant inflation? Are interest rates rising or falling? Are consumers burdened with massive debt? Is the currency exchange rate good for exports? By determining the state of the general economy, we construct a ‘frame’ within which stocks can be gauged.
Strength of the Industry Sector
Even the strongest company will fail if it’s sector is in trouble. For example, there were a large number of buggy whip makers at the turn of the last century, some possessing large cash balances, tight operations, and apparently excellent prospects. A old chestnut proclaims that ‘a weak stock in a strong sector is better than a strong stock in a weak sector’. A good recent example would be the telecom sector. Until 2000, even mediocre telecoms companies enjoyed massively overpriced stock prices. Now they have to function in the real world again, because the sector as a whole hit enormous trouble at the start of the new century.