Fundamental analysis is an approach to judging the value of investment securities. This approach takes into account the broader economic context in which the given security is situated and the specific characteristics of the security. All of this data is then compared to the security’s current market price. This is done with an eye toward determining whether the security is fairly-valued, overvalued, or undervalued. A thorough and reliable fundamental analysis is an invaluable resource for making investment decisions.
Fundamental analysis consists of three principal elements. These include economic analysis, industry analysis, and company analysis. In this enumeration, we move from the broader scope (analysis of the whole economy) to progressively narrower scopes (the analysis of the company’s industry, and then the analysis of the company itself). As we’ll see, however, a variety of perspectives may be taken on this data. This allows for a holistic and situational picture of the company and its context to be obtained.
What is Fundamental Analysis?
Fundamental analysis is a technique used by financial analysts to determine how much a given company is worth. This determination is then used to evaluate the price given to that company’s stock on the public markets. The prevailing economic conditions are considered. For example, the question is asked whether the economy is growing or shrinking. In addition, the industry of which the given company forms a part is analyzed: Where does the company stand in relation to its competitors? Another element of fundamental analysis relates to the characteristics of the company in question. For example, what is the company’s debt burden?
How is Fundamental Analysis Performed?
There are two basic approaches to How to Do Fundamental Analysis. The first takes a top-down approach as follows:
- Macroeconomic: Analysis of the economic context at the broadest possible levels.
- Sector: Moving to a finer level, the state of the sector, i.e. of the industrial sector for an auto-manufacturing company, is considered.
- Industry: Focusing closer, the situation of the company’s specific industry, i.e. automobile manufacturing for our example, is evaluated.
- Company: Finally, at the closest level of analysis, the characteristics of the company itself are taken into account.
The other mode of fundamental analysis reverses this, and takes a bottom-up approach:
- Company: Begin with the company’s characteristics: Its financial data, marketing techniques, ongoing projects, etc.
- Industry: Next, consider the industry in which the company operates. This will include both the health and progress of the industry, as well as the company’s primary competitors.
- Sector: In the example of an automobile company, you’ll now move on to analyzing the situation of the manufacturing sector more broadly.
- Economy: Finally, with all of the above in mind, conduct an analysis of the state of the broader economy, from the domestic to the global levels.
Why is Fundamental Analysis Necessary?
Fundamental analysis is necessary for making the best-informed investment decisions that you can make about a given company. Without accurate, precise, and up-to-date information concerning all of the various areas and contexts in which a company operates, it’s impossible to know whether or not a company’s stock price is fair, and so whether or not it’s a good idea to purchase that company’s securities. Fundamental analysis allows you to determine whether a security is overpriced, underpriced, or fairly valued. If, after fundamental analysis, we learn that security is overpriced and that it’s a bad idea to purchase that security. On the other hand, if we learn that security is underpriced, it’s more likely that buying that security is a good investment decision.
Who Performs Fundamental Analysis?
Although fundamental analysis is a basic tool of financial analysts, anyone who is interested in determining the proper valuation of a company’s securities can use the technique. For example, investors benefit from fundamental analysis in making their investment decisions. Lenders use fundamental analysis to decide whether or not lending money to a given company is worth the risk. People connected to a company, from board members to employees, can benefit from fundamental analysis to find out if their company is in a robust state of health or not. Even consumers may avail themselves of fundamental analysis when making large purchases, in order to find out whether the company from which they are buying is likely to survive over the long term.
What are the Examples of Fundamental Analysis?
- First, select a company.
- Then, choose your approach.
- If you’ve selected a top-down analysis, dive into research on the economy at the broadest levels.
- Once you have a clear idea of the macroeconomic situation, you’ll then need to consider the sector and industry of the company you’re interested in. If you’ve selected General Motors, for example, you’ll need to consider the state of the manufacturing sector, and then the state of the automobile industry, including GM’s competitors.
- Once you have a good grasp of the company’s environment at these various levels, it’s time to delve into the specifics of the company itself. How much debt does it hold? Has the company shown consistent growth from year to year? Is the company investing in research and development to improve its competitive edge? These are just some of the questions you’ll need to ask in order to make a judgment on whether General Motors’ stock price is fairly valued.
What are the Types of Fundamental Analysis?
There are several types of fundamental analysis. These include top-down and bottom-up approaches to fundamental analysis, which vary based on the starting point adopted for considering the value of a company. Another variable by which different types of fundamental analysis may be distinguished is the qualitative/quantitative axis. Quantitative analysis is mainly concerned with public perception and reception of the company. It considers the extent to which the company’s brand is publicly recognized, the demand for its products, and the degree of success that characterizes its marketing initiatives, for example. Qualitative analysis, for its part, relies upon the study of statistics and data. This type of fundamental analysis takes into consideration things like balance sheets, fluctuation in stock prices, and patterns of growth over various periods of time.
What are the Components of Fundamental Analysis?
The main components of fundamental analysis include the analysis of a company and its situation on various levels. If you’re adopting a top-down approach, the first component you’ll need to consider is the broader economy. The next component in the analysis is the sector. Following the sector, you’ll need to have a look at the industry that includes the company. Finally, you come to detailed consideration of the company itself, which forms the final component according to this approach.
Is Fundamental Analysis Always Effective?
Fundamental analysis is not always effective. This is mainly because the fundamental analysis can only use the available data while investing in securities only becomes successful with the passage of time: None of us can know what will happen in the future, so it’s impossible to be 100% sure that your investments will be profitable. Yet from another point of view, it’s almost always a good idea to have as much information and understanding of the company in which you will be investing your hard-earned money. Thus, even if fundamental analysis can’t guarantee success, it’s always a good idea to apply fundamental analysis to the company you’re interested in, prior to investing.
Is Fundamental Analysis more Reliable than Technical Analysis?
For long-term investing, fundamental analysis is more reliable than technical analysis. This is because fundamental analysis takes into account a wide variety of factors and contexts in order to give as holistic as possible a view of a given company. This is opposed to technical analysis, which is generally limited to looking at the trading patterns for a given security’s stock. With short-term trading, however, it’s easy for the vagaries of the market to become temporarily disconnected from the fundamentals of the underlying company. This means that technical analysis has its place, too, for example, if you’re trying to time the market to get the best value for your investment.
What is the Difference Between Fundamental Analysis and Technical Analysis?
Fundamental analysis is different from technical analysis in that fundamental analysis considers a variety of contexts and circumstances, beginning from the broader economic situation and moving through the sector and industry levels to reach a detailed analysis of a given company’s health and potential. Technical analysis, on the other hand, is concerned with the patterns that govern the price action of a given company’s stock. Each of these kinds of analysis has its own particular use. Fundamental analysis is the more thorough and reliable kind of analysis, and it should be used when making long-term investment decisions. Technical analysis, on the other hand, is generally used when making short-term investments that seek to profit off of market moves.