Value investors uses all most all type of financial tools available in fundamental analysis based on their requirements to measure a security’s intrinsic value by examining related economic and financial factors.
These fundamental analysts think that if they do their homework right, understand the company’s business better, accurately forecast its earnings and buy the stock at the right price, then they can achieve success in stock market.
However, like any other tools, fundamental analysis also has its own limitations.
As a value investor, you must know the limitations of fundamental analysis and adjust your strategy accordingly to overcome it while taking a investment decision.
Fundamental Analysis is based on wrong data
Fundamental analysis is based on reported and publicly available data. But if the management has incorrectly reported financial details or you have misinterpreted it, then your decision may go wrong.
It’s also necessary to base your analysis on relevant and accurate data.
In case of an accounting scandal, investors might start selling the stock indiscriminately due to which the stock price may beaten down below your calculated intrinsic value. In such type of situation, fundamental analyst generally avoid buying as financial information can’t be relied upon.
You should change your analysis based on the recent changes in the company decisions and predict financial data accordingly.
Stock may also trade below their intrinsic value in case of rumors or cases where the company is about to face massive claim. You have to be very careful as analysis based on past data which will have no relevance now as future profit gets affected if claim settled. This generally happens in pharma companies due to regulations.
Incorrect Assumptions in Fundamental analysis
While projecting company’s profitability based on its assumed growth rate, future interest rates and other factors, you have to base these projections on correct achievable assumptions based on credibility of management and industry growth rate.
In case of high expectations and unachievable estimations, your whole investments can go wrong.
Over reliance on past data
Financial analysis uses historical financial data to predict future earnings based on expected growth rate. These historical data used to predict future are published after 3 month or more. There can be some exception to the period. Blindly relying on these historical numbers can be dangerous.
Some time over-enthusiasm for stocks can move their prices to a level that is fundamentally not justified by their underlying businesses. Fundamental analysis can be a great help to find such bubble. Before such bubble bursts, fundamental analyst will look for opportunity to profit from it.
In certain cases, you might find a company matures due to which you may see slow growth in revenue and earnings in comparison to past growth. In such a situation, analysis based on past financial data need to be recalculated based on new growth rate.
Industrial disruption might takes place if any unexpected changes happen in a economy or any new higher tax rates is going to impact company’s profitability.
Please note, if you can rediscover value in a beaten down stock, then it can rally strongly when other investor starts recognizing the same value and future growth.