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Fundamental analysis

Fundamental analysis attempts to value an investment using 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. Linear projections based on five year averages are usually adequate.

Fundamental analysis attempts to value a company by analysing its balance sheet and income statement. Ratio analysis is undertaken to determine the likely performance of the company.

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.

Sometimes earnings multiples are used to determine value, where cash flows are relatively stable and predictable.

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. The goal of this research should be to determine whether the company has good practices, and whether its management is honest.

See also: risk aversion Warren Buffett