fundamental analysis

Fundamental analysis (FA) is one among others stock valuation methods. It can be labelled as the use financial analysis for valuation. Valuation can be separated into these steps:

analyse the financial statements
analyse their operations
analyse the world in which they operate
evaluate the growth potential
In futures the intrinsic value of the underlying commodity, rather than technical analysis based on relative prices.

Techniques

Ratio analysis is for example undertaken to determine the likely performance of the company. Financial analyses uses among others discounted cash flow analysis. Generally, the analyst estimates the expected future cash flow of the investment, and uses projections of interest rates to assess the present value of the cash flow. Book value can also play a part, some takeovers and cessions being based on such a criteria. Also dividends might be taken into account, as the direct income shareholders can expect, capital gains being more hypothetic for them

Pitfalls

Linear projections based on five year averages are usually adequate, but this need to add the final discounted value at the end of the period (either a projected book value, or a string of cash-flows based on the general economic growth).

The choice of the discounting rate is tricky, It should normally should include a risk premium, but this is debated (see risk aversion, risk premia puzzle, behavioral finance)

A crucial concern of many investors is to obtain a large margin of safety when making an investment. It is well known that forecasting future earnings and interest rates is difficult, and estimates of these are often unreliable.

Alternative or additional techniques

Multiples

Sometimes earnings multiples, such as the PE ratio, are used to determine value, where cash flows are relatively stable and predictable. This market-based criteria can take into account behavioral parameters, for example the stock image. The obvious caveat is that the price/earnings ratio doesn't show if a company is "expensive" or really is a "high growth rate" company.

Different views

Another complementary method is to interview employees, competitors, vendors and customers about a company. Often these people will know as much or more about a company than its management. One of the goals of this research should be to determine whether the company has good practices, and whether its management is honest.