Fundamental analysis (FA) refers to the process of studying any security’s intrinsic value with the object of making profits while trading in it. The primary purpose of fundamental analysis is to determine whether the security or stock is undervalued or overvalued and thereby make an informed decision to buy, hold, or sell it in order to maximize the potential for gains.
Fundamental Analysis in simple terms in the art of evaluating any business to its basics and getting an accurate picture of how financially healthy and sustainable it is. It involves studying a company’s potential for future growth by considering various micro and macroeconomic factors. This analysis assists in deriving at an intrinsic value of stock that aids investment decisions.
Table of contents
- What is Fundamental Analysis?
- Fundamental analysis is the method to determine the intrinsic value of any security or stock by comparing key ratios to find out a company’s financial health.
- The purpose of conducting fundamental analysis is to identify investment opportunities and benefit from them.
- There are two types of fundamental analysis – Qualitative and Quantitative. Qualitative is inclined towards goodwill, market conditions, brand value, and company performance. In contrast, the quantitative analysis is statistically driven.
- Fundamental analysis is often compared with technical analysis. While the former focuses on understanding all factors affecting a company to help stock selection, the latter involves studying stock price movements to time buying and selling of stocks.
Understanding Fundamental Analysis Basics
Fundamental analysis assesses a company’s potential based on financial and non-financial data to obtain the fair valueFair ValueThe fair value of an investment is the asset sale price that is agreeable to both the buyer and the seller. There is a caveat; the amount should be agreeable in a free trade scenario; there should be no external pressure or conditions. of its security, stock, bondBondBonds refer to the debt instruments issued by governments or corporations to acquire investors’ funds for a certain period., or derivativeDerivativeDerivatives in finance are financial instruments that derive their value from the value of the underlying asset. The underlying asset can be bonds, stocks, currency, commodities, etc. The four types of derivatives are - Option contracts, Future derivatives contracts, Swaps, Forward derivative contracts. . It is a powerful tool for investors and stakeholdersStakeholdersA stakeholder in business refers to anyone, including a person, group, organization, government, or any other entity with a direct or indirect interest in its operations, actions, and outcomes. to understand the growth prospects and financial health of a company. Therefore, it is one of the most effective ways to evaluate investments.
It involves examining every aspect of a company’s operations through its balance sheetBalance SheetA balance sheet is one of the financial statements of a company that presents the shareholders' equity, liabilities, and assets of the company at a specific point in time. It is based on the accounting equation that states that the sum of the total liabilities and the owner's capital equals the total assets of the company., past performance, financial reportsFinancial ReportsFinancial reporting is a systematic process of recording and representing a company’s financial data. The reports reflect a firm’s financial health and performance in a given period. Management, investors, shareholders, financiers, government, and regulatory agencies rely on financial reports for decision-making., even market goodwill, management, and consumer behavior to arrive at the intrinsic value of its securities.
The analysis begins from macroeconomic factorsMacroeconomic FactorsMacroeconomic factors are those that have a broad impact on the national economy, such as population, income, unemployment, investments, savings, and the rate of inflation, and are monitored by highly professional teams governed by the government or other economists. such as the economy and industry performance and goes down to microeconomic factors like management, strategic initiatives, and business policies. Note that the analysis can also start at the microeconomicMicroeconomicMicroeconomics is a ‘bottom-up’ approach where patterns from everyday life are pieced together to correlate demand and supply. level and then move to macro components.
On conducting Fundamental analysis, if an investor deduces that a stock’s intrinsic valueIntrinsic ValueIntrinsic value is defined as the net present value of all future free cash flows to equity (FCFE) generated by a company over the course of its existence. It reflects the true value of the company that underlies the stock, i.e. the amount of money that might be received if the company and all of its assets were sold today. is greater than its market priceMarket PriceMarket price refers to the current price prevailing in the market at which goods, services, or assets are purchased or sold. The price point at which the supply of a commodity matches its demand in the market becomes its market price., it means the stock is undervalued. In that scenario, the investor buys such stock and holds it until the market price reaches the intrinsic value. Then, the investor makes a sizeable profit on selling at intrinsic market price.
Similarly, an investor may decide to sell or refrain from buying an overvalued security. Being overvalued means that the stock’s intrinsic value is less than its market price. Thus, FA may guide investors to manage risks and make informed investing decisions by ascertaining the intrinsic value of a stock. Financial ratiosFinancial RatiosFinancial ratios are indications of a company's financial performance. There are several forms of financial ratios that indicate the company's results, financial risks, and operational efficiency, such as the liquidity ratio, asset turnover ratio, operating profitability ratios, business risk ratios, financial risk ratio, stability ratios, and so on. calculated using data from the financial statements are the primary tool of FA.
Blindly investing in stocks without conducting FA may result in major losses, as revealed by the dot-com bubble in 2008-09. Thus, investors should employ fundamental analysis to make conclusions about companies and their securities. However, in practice, it should be used in conjunction with another process called technical analysis.
The technical analysisTechnical AnalysisTechnical analysis is the process of predicting the price movement of tradable instruments using historical trading charts and market data. involves closely observing the stock price movements to predict the future and make investment decisions. It depends on past trends, stock chartsStock ChartsThe stock chart can be defined as a pictorial/ graphical representation of a price of stock plotted for a period, i.e., either daily, weekly, monthly, yearly, etc. containing items like stock symbol, stock exchange details, price details like open, close, highest, lowest, etc. and trade volume details, i.e., the quantity of stock bought and sold providing insights about the direction in which stock will be moving., and price history to look for stocks that may perform better in the long run. Hence, technical analysis can be called the fundamental analysis of the stock market.
Video: Fundamental Analysis vs. Technical Analysis
Types of Fundamental Analysis
FA is used in many areas and is classified into two types –
#1 – Qualitative analysis
Qualitative analysis involves the study of a company’s goodwillGoodwillIn accounting, goodwill is an intangible asset that is generated when one company purchases another company for a price that is greater than the sum of the company's net identifiable assets at the time of acquisition. It is determined by subtracting the fair value of the company's net identifiable assets from the total purchase price., consumer behavior, demand, and company recognition in broader markets. It aims to unearth answers to questions like how it is perceived, how management decisions or announcements create a buzz in the market, and how it is different from its substitutes. In addition, its brand value and other common factors depict its socio and economic position in the market.
#2 – Quantitative analysis
Quantitative analysis is inclined towards statistics, reports, and data. It is solely based on its financial statements, quarterly performance, balance sheets, debt, cash flowCash FlowCash Flow is the amount of cash or cash equivalent generated & consumed by a Company over a given period. It proves to be a prerequisite for analyzing the business’s strength, profitability, & scope for betterment. , etc. It involves analyzing numbers, ratios, and values to understand the price of the shares and the company’s overall financial health.
Steps to do Fundamental Analysis
Two approaches are generally used in performing FA of a company:
#1 – Top-down approach
In this approach, experts start from macroeconomic factors assessing the economyEconomyAn economy comprises individuals, commercial entities, and the government involved in the production, distribution, exchange, and consumption of products and services in a society. and industry first. Then, they come down to market conditions and ultimately to evaluating a company’s progress, management, and other microeconomic factors.
#2 – Bottom-up approach
This approach is the vice versa of the top-down course. It starts with studying the company, digging up its record and performance, and then slowly moving upwards to macroeconomic factors like industry conditions and a country’s economy.
A step-by-step execution is initiated to perform a fundamental analysis of stocks, securities, or companies. The critical aspects of it are –
1. Economic, industry, and company analysis
FA considers the industry’s structure, economy, industry dynamics, aspects of broader markets, and all the other macroeconomic factors.
The experts study the products, commodities, services rendered, and substitutes available along with cost structure and revenue model and composition and the company’s future goals and objectives.
2. Evaluation of financial statements
Every company report is studied closely – the balance sheets, income statementIncome StatementThe income statement is one of the company's financial reports that summarizes all of the company's revenues and expenses over time in order to determine the company's profit or loss and measure its business activity over time based on user requirements., cash flow, price to book value of equity, the net market value of assets, and other vital ratios with revenue.
3. Study of non-financial aspects
Besides a company’s financial statementsFinancial StatementsFinancial statements are written reports prepared by a company's management to present the company's financial affairs over a given period (quarter, six monthly or yearly). These statements, which include the Balance Sheet, Income Statement, Cash Flows, and Shareholders Equity Statement, must be prepared in accordance with prescribed and standardized accounting standards to ensure uniformity in reporting at all levels., non-financial matters like competition, management, business policies, etc., also influence a company. Therefore, in the FA of stocks, experts also look for factors that can influence or undermine the company’s performance.
4. Use of FA tools
Investors and analysts use financial ratios to determine a company’s financial standing. It is used along with the available financial data from past reports to measure future growth, stability, and investment.
Fundamental Analysis Examples
The disintegration of the auto-giant General Motors stocks in 2009 is one of the glaring examples of the risks of ignoring fundamental analysis. Unfortunately, investors who missed the fundamentals bore the brunt of the massive collapse of the GM stock that led to GM filing bankruptcy protection.
A 2018 research study by Raúl Navas, Ana Paula Matias Gama, and Sónia R. Bentes investigates the significance of FA in understanding the worth of a company. The study concludes that the investors can use FA scores to create a portfolio that is likely to yield them remarkable returns within a year or two. The research also adds to the understanding of mispriced stocks in the European capital market.
Frequently Asked Questions (FAQs)
The process typically starts with considering the broader markets, first an economy and then a particular industry. After that, the company specifics are studied to understand how it stands in the financial market with its performance, growth, and value.
So, in a way, it is analyzing a particular company’s financial parameters along with the economy and broader markets to decipher the intrinsic value of its security or bond to understand whether it is undervalued or overvalued.
While performing fundamental analysis in FOREX, the experts carefully measure the social, political, and market influence on a currency’s relative value. Thus, it helps the FOREX traders understand what drives a currency’s intrinsic value and make wise investing decisions.
It is used to compute whether any security or stock is undervalued or overvalued. FA can be performed on any security, bond, stock, derivative, or even a company to comprehend its position and value in the economy and financial markets.
This has been a guide to Fundamental Analysis. Here we discuss the meaning of fundamental analysis along with its types, steps, & examples. You can learn more about financing from the following articles –