Question

Fundamental analysis uses information in a firm’s financial statements and other sources of public

information to assess a firm’s expected future performance, and hence its likely value. Firms with

estimated values greater than their current prices are then recommended as buys and those with values

lower than the current price as sells.

 Intergalactic Software Company went public three months ago. You are a sophisticated investor who

devotes time to fundamental analysis as a way of identifying mispriced stocks. Which of the following

characteristics would you focus on in deciding whether to follow this stock?

 Market capitalization (will influence the extent of interest of institutional interests)

 The average number of shares traded per day

 The bid-ask spread for the stock

 Whether the underwriter that brought the firm public is a top tier investment banking firm

 Whether the firm’s audit company is a Big Four firm

 Whether there are analysts from major brokerage firms following the company

 Whether the stock is held mostly by retail or by institutional investors

Include in your response: What is a sophisticated investor and a comprehensive description of what is

included in a fundamental analysis of a company.

Answer 1

Fundamental ianalysis i(FA) iis ia imethod iof imeasuring ia isecurity's iintrinsic ivalue iby iexamining irelated ieconomic iand ifinancial ifactors. iFundamental ianalysts istudy ianything ithat ican iaffect ithe isecurity's ivalue, ifrom imacroeconomic ifactors isuch ias ithe istate iof ithe ieconomy iand iindustry iconditions ito imicroeconomic ifactors ilike ithe ieffectiveness iof ithe icompany's imanagement.

1. Fundamental ianalysis iis ia imethod iof idetermining ia istock's ireal ior i"fair imarket" ivalue.

2. Fundamental ianalysts isearch ifor istocks ithat iare icurrently itrading iat iprices ithat iare ihigher ior ilower ithan itheir ireal ivalue.

3. If ithe ifair imarket ivalue iis ihigher ithan ithe imarket iprice, ithe istock iis ideemed ito ibe iundervalued iand ia ibuy irecommendation iis igiven.

4. In icontrast, itechnical ianalysts iignore ithe ifundamentals iin ifavor iof istudying ithe ihistorical iprice itrends iof ithe istock.

All istock ianalysis itries ito idetermine iwhether ia isecurity iis icorrectly ivalued iwithin ithe ibroader imarket. iFundamental ianalysis iis iusually idone ifrom ia imacro ito imicro iperspective iin iorder ito iidentify isecurities ithat iare inot icorrectly ipriced iby ithe imarket.

i i i i i i i i i i i i i i iAn ianalyst iuses iworks ito icreate ia imodel ifor idetermining ithe iestimated ivalue iof ia icompany's ishare iprice ibased ion ipublicly iavailable idata. iThis ivalue iis ionly ian iestimate, ithe ianalyst's ieducated iopinion, iof iwhat ithe icompany's ishare iprice ishould ibe iworth icompared ito ithe icurrently itrading imarket iprice. iSome ianalysts imay irefer ito itheir iestimated iprice ias ithe icompany's iintrinsic ivalue.

Intrinsic ivalue

i i i i i i i i i i i i i i i i i i i i i i i i iOne iof ithe iprimary iassumptions iof ifundamental ianalysis iis ithat ithe icurrently iprice ifrom ithe istock imarket ioften idoes inot ifully ireflect ia ivalue iof ithe icompany isupported iby ithe ipublicly iavailable idata. iA isecond iassumption iis ithat ithe ivalue ireflected ifrom ithe icompany's ifundamental idata iis imore ilikely ito ibe icloser ito ia itrue ivalue iof ithe istock.

Analysts ioften irefer ito ithis ihypothetical itrue ivalue ias ithe iintrinsic ivalue. iHowever, iit ishould ibe inoted ithat ithis iusage iof ithe iphrase iintrinsic ivalue imeans isomething idifferent iin istock ivaluation ithan iwhat iit imeans iin iother icontexts isuch ias ioptions itrading. iOption ipricing iuses ia istandard icalculation ifor iintrinsic ivalue; ihowever ianalysts iuse ia ivarious icomplex imodels ito iarrive iat itheir iintrinsic ivalue ifor ia istock. iThere iis inot ia isingle, igenerally iaccepted iformula ifor iarriving iat ithe iintrinsic ivalue iof ia istock.

The ibid-ask ispread ifor ithe istock

Stock iexchanges iare iset iup ito iassist ibrokers iand iother ispecialists iin icoordinating ibid iand iask iprices. iThe ibid iprice iis ithe iamount ia ibuyer iis iwilling ito ipay ifor ia iparticular isecurity, iwhile ithe iasking iprice iis ithe iamount ia iseller iwill itake ifor ithat isecurity.

One iof ithe ibasic iconcepts iof iinvesting iis ithe ibid-ask ispread, iwhich ican ibe iused iin idifferent ifacets iof ia iperson's ifinancial ilife, ifrom ibuying ia ihome ior icar. iIt ican ieven ibe iused ito inegotiate ithe ipurchase iof istocks. i

The ibid-ask ispread iis ivery iimportant iin ithe imarketplace. iIt's ithe idifference ibetween ithe ibuyer's iand iseller's iprices ior iwhat ithe ibuyer iis iwilling ito ipay ifor isomething iversus iwhat ithe iseller iis iwilling ito iget iin iorder ito isell iit.

i i i i i i i i i i i i i i i i i i i i i i i i i i i i i i i i i i iA istock's iprice ialso iinfluences ithe ibid-ask ispread. iIf ithe iprice iis ilow, ithe ibid-ask ispread iwill itend ito ibe ilarger. iThe ireason ifor ithis iis ilinked ito ithe iidea iof iliquidity. iMost ilow-priced isecurities iare ieither inew ior ismall iin isize. iTherefore, ithe inumber iof ithese isecurities ithat ican ibe itraded iis ilimited, imaking ithem iless iliquid.