Everything had its merits and demerits. No matter how good fundamental analysis is it also have some limitations.
They may be structural or methodical.
Investor must have very good idea of such flaws in order know which piece of puzzle is missing and what can go wrong in analysis.
So here is the list of 12 limitations of fundamental analysis.
Assumptions need to be taken in intrinsic value calculation
Main aim for doing fundamental analysis to calculate intrinsic value of financial instrument to find undervalue opportunities. For this models are used like discounted cash flow valuation.
To get intrinsic value as output in any model many assumptions have to be used.
Some of this assumptions are
- Estimation of free cash flow over remaining life of business.
- Discount rate.
- Growth rate of company.
Achievement of investment objective is based on quality of such assumptions.
But this assumptions very hard to get right. As you can see it is nearly impossible to know revenue or cash flow of company after 10 years. Also there are many confusing theories about which discount rate should be considered.
Wrong estimation of one figure by just few percentage can cause huge loss to investors because of this assumptions are prime limitation of fundamental analysis.
Works only for longer term investments
Fundamental analysis is done because markets are irrational .It time to time gives opportunities to buy stocks at price cheaper than its actual price.
Markets sooner or later realizes actual value and adjust itself according to it. But this process takes time, which may extent one year to several years.
Because of this underlying philosophy of fundamental analysis it cannot be used for short term.
Benjamin Graham has famously said that “Markets can remain irrational enough to make investor bankrupt.”
Only focuses on qualitative factors and ignore qualitative factors
Financial models which I talked about earlier are based on numbers. In other words they only consider quantitative factors of business. But there are many non numerical factors which significantly define how business will perform in near future.
Such non numerical factors are
- Quality of management.
- Nature of competition.
- Off balance sheet value of company (brands).
- Unique distribution network company have.
With the help of fundamental analysis investor cannot find numerical value of such factors or extent of strength and competence business get because of them.
But some factors do reflect in numbers. For example efficiency in business model is reflected in working capital of company. Understand such kind of thing require lot of experience and understanding of businesses.
Inability to detect frauds
Frauds are done by manipulating accounting numbers to avoid reality reflecting in financials. Fundamental analysis is also about understanding economic reality of businesses with the help of numbers.
No matter how professional experienced and skeptical investors are frauds are next to impossible thing.
Despite of digging deep in numbers fundamental analysis fails to find frauds.
Not all blame goes to analysis process accounting system which require management assumptions to reach creating numbers like depreciation and amount of disclosures required by regulatory systems are also equally responsible.
Time taken to do fundamental analysis is so large
To do fundamental analysis of just one company investor have to do
- International and national economic analysis
- Research on industry.
- Business analysis.
- Competitors analysis.
There are thousands of companies listed on exchanges. So the probability that you will find best investment in first turn is very low.
So to find one good opportunity it may take several months to even years. Thus lengthy and complex process which gives multibagger opportunities is also a limitation of fundamental analysis.
Markets may be faster to react than financial data
Markets are anticipatory in nature because all participants in markets (we humans) have some kind of anticipations regarding to future events.
If any positive or negative thing happens with company which was anticipated by market then in this case.
Say a company has announced merger and whole market is expecting positive for company then in this case waiting for results to be reflected in financial information will not be helpful.
Suppose there are only four companies in a particular industry. Because of some reasons two of them get shut down then in other two will surely get benefit. In such scenario investing based on experience knowledge is best because it will be too late it person wait annual report to figure out how helpful this event was or will be in future.
Financial information can be manipulated
There is another type of manipulation which cannot be molded in category of fraud. But causes wrong decision making by investors.
Such manipulation may be with the help statistics also.
If any CEO makes statement that profit after tax of company is increased by 75 %. This is huge milestone achievement for company many investor will jump into the stocks .
But most of the time such huge leaps in profits are due to extraordinary items like sell of fixed assets or investments.
Another is making significant changes in assumptions regarding with reserves and provisions so as to decrease expenses.
But there is solution to get over this limitation of fundamental analysis for this read each and every note to account on the financial statement get understanding how each figure is derived.
Require advanced accounting knowledge to evaluate complex institutions
Many companies very big. They have many subsidiaries, joint ventures and associates operating in different economic environment . analyzing such companies is very time consuming and complex task investor needs to have good industry knowledge. Understanding of each economies in which subsidiaries operative knowledge competitiveness of thousands of products.
Other problem is that some firms have derivatives like futures they have special purpose entities in their books. accounting of such is very complex. So there is much more room to do wrong things. Possibility of mistake to figure out all aspects right is very large.
Do not give exact buy or sell signal
Technical analysis is based on chart patterns which gives pin point buy and sell signal. As opposed to this fundamental analysis only tells about undervaluation and overvaluation.
It is like jumping into the river from 1000 feet tall cliff where you know river is deep but don’t know how deep it is. It may be 2 feet deep only.
Same thing with fundamental valuations. If stock is undervalued, but just by 2 % of current market price then there is no point in investing there.
Large number of factors affecting any business and difference in their weight form business to business makes it impossible to assess all of them
Take any business and ask which factors or variables will affect profitability of this business?
Answer will be long list of geopolitical, technical, economical, competitive factors, industrial factors.
Not all factors affect every business in the same way. For example increase in crude oil prices can take whole airline industry in loss as oppose to this financial services sector will remain unaffected by this.
There is strong probability than investor will miss any important factor to take in consideration to evaluate stock.
Sometimes some technical factor suddenly appears. which could not have been predicted by any stretch of imagination. Such things not only destroy a particular company but whole industry.
Just like DVD and CD’s were destroyed by streaming services like Netflix and Amazon Prime.
Many theories in fundamental analysis have opposite views and many of them cannot be applied in real world
Use Beta (measure of price volatility) as indicator of risk.
Efficient market hypothesis : All peoples behaves rationally and stock do reflect all information at that time, so all stocks are fairly valued for all the time. Which is why no one can beat market indices.
Confusion regarding which model of valuation to use(divided discount model or discounted cash flow model or residual value model).
This creates whole lot of confusion.
Needs constant track of whole lot of variables.
As discussed earlier there are many factors affecting businesses so when anything changes investor also have to absorb this information to make right decision.
This sometimes becomes impossible due to large number of stocks in portfolio and limited capacity of human brain to store and process large amount of information.
Limitations of fundamental analysis seems to be large in number. But in past it has shown best investment results than any other type of analysis. Purpose of this article is not to show how fundamental analysis is bad and should not be used but rather it is guide to know where to be careful.