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How Important is Economic Analysis For Fundamental Analysis of Stocks?

BY: Vivek SHARMA | Category: Finance | Submitted: 2012-02-29 08:24:48
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Article Summary: "The article highlights the role of economic analysis in fundamental analysis.."

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Fundamental analysis is defined as method of evaluating a security which helps in identifying the intrinsic value of a stock. Fundamental analysis is often done by analysing economic, industry and company specific factors. There are two approaches to fundamental analysis which are defined as 1) Top Down and 2) Bottom Up approach. Top down approach starts with analysing economy , industry and then goes on to evaluate company specific factors. In bottom up approach, reverse happens. However, in spite of these two approaches fundamental analysis is completely different in practice. Most of the approaches to fundamental analysis of stock emphasizes on the performance of company and the industry in which it operates, not much significance is given to economic analysis.

It has been observed that analysts evaluating intrinsic value of a company, try to work out cash flow of the company and in many cases using P/E approach they find the intrinsic value of the shares of a company. All these analysis are based on some assumptions. Even in the space for assumption, very little weightage is given to economy related factors. Most of the times, factors such as inflation and interest rates are considered but wider factors such as GDL growth, fiscal policy, foreign exchange movement are ignored. As a result of this fundamental analysis becomes very shallow and fails to predict the value of a stock.

The problem lies in the fact that most of analysts have very limited understanding of economy. Being management graduates, CAs or CFAs, these analysts are more focused on numbers that come out from company data. Since there is a limited understanding of economy, they tend to either ignore or undermine the role of economic factors. There are very studies done to check the performance between a stock price movement and GDP growth. Hence it becomes very difficult to quantify impact of such variables but the fact remains that they continue to impact share price. This is one of the reason that in scenarios of global crisis, almost all approaches of share valuation start looking kiddish.

The correct approach of equity valuation should ideally include the in depth analysis of stock industry and economy related factors as well, otherwise fundamental analysis will continue to work on several limitations that it has.

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