¹The University of Tennessee, Knoxville, TN, USA

Correspondence: NCP Edirisinghe, SMC 610, College of Business Administration, University of Tennessee, Knoxville, TN 37996, USA. E-mail: chanaka@utk.edu

Received March 2005; Accepted April 2007; Published online 20 June 2007.

Abstract

Fundamental analysis is an approach for evaluating a firm for its investment-worthiness whereby the firm's financial statements are subject to detailed investigation to predict future stock price performance. In this paper, we propose an approach to combine financial statement data using Data Envelopment Analysis to determine a relative financial strength (RFS) indicator. Such an indicator captures a firm's fundamental strength or competitiveness in comparison to all other firms in the industry/market segment. By analysing the correlation of the RFS indicator with the historical stock price returns within the industry, a well-informed assessment can be made about considering the firm in an equity portfolio. We test the proposed indicator with firms from the technology sector, using various US industries and report correlation analyses. Our preliminary computations using RFS indicator-based stock selection within mean–variance portfolio optimization demonstrate the validity of the proposed approach.