Understanding fundamental analysis
Fundamental analysis (FA) is a method used to evaluate the intrinsic value of a financial asset such as a stock, bond, or commodity. The analysis requires consideration of various economic, financial, and other qualitative and quantitative factors that can affect the security’s price.
To that end, FA examines factors such as a company’s financial statements, earnings, revenue, profits, dividends, assets, liabilities, and cash flow, in addition to macroeconomic indicators, industry trends, and regulatory changes. Analysts use this information to estimate the fair value of an asset and whether it is overvalued, undervalued, or fairly priced.
Thus, it may come as no surprise to learn that FA is used in the stock market to evaluate a company’s performance and determine its future growth potential. Note that fundamental analysis is often used in conjunction with technical analysis (TA) which concerns historical price trends and movements in the market.
Fundamental analysis techniques
With vast amounts of information on a company and its industry to assess, fundamental analysis can be difficult – especially for new or inexperienced investors.
Those that are more seasoned, however, use various financial ratios to capture the essence of the data and make sense of it. Some look for consistent earnings growth, while others may be interested in low debt levels or the security’s dividend potential.
Here are some common methods:
- Financial statement analysis – as the name suggests, this involves analyzing a company’s financial statements (balance sheet, income statement, and cash flow statement) to assess its financial health and profitability.
- Ratio analysis – this includes the price-to-earnings (P/E), price-to-book (P/B), debt-to-equity (D/E), and return on equity (ROE) ratios to understand a company’s financial performance relative to its peers.
- Discounted cash flow (DCF) analysis – to determine a company’s intrinsic value, the investor can estimate future cash flows and discount them back to their present value with a discount rate.
- Industry analysis – this considers the overall performance of the industry in which the company operates and may include factors such as supply and demand.
- Macroeconomic analysis – which includes factors such as interest rates, inflation, GDP growth, and any other quantitative factor that can affect the economy and company’s performance.
The qualitative aspects of fundamental analysis
Note that a fundamental analysis is not all about the numbers – various qualitative aspects also require careful consideration.
- Company management – the quality and experience of a company’s management team is one qualitative aspect that many investors prioritize. They consider management’s track record, strategic vision, communication with investors, and whether leaders have been involved in success at other companies.
- Competitive landscape – in addition to quantitative factors such as supply and demand, investors may consider barriers to entry and the threat of substitutes.
- Regulatory landscape – regulation and governmental policy can also impact the trajectory of a company’s share price. For example, many are weary of investing in companies that operate in corrupt, autocratic, or lawless parts of the world.
- Brand value – in some cases, brand value can also be incorporated into FA because it influences customer satisfaction, market share, and pricing power.
- Industry – fundamental analysts may also consider broader industry trends such as consumer behavior, innovation, and demographic shifts that affect the demand for a company’s products or services. The electric vehicle revolution, for example, has seen investor interest in lithium and other battery metal companies soar to levels unimaginable just a few years back.
- A fundamental analysis is a technique used by investors to determine a company’s intrinsic value. In other words, the fair market value of its stock.
- With vast amounts of information on a company and its industry to assess, fundamental analysis can be difficult. To make sense of quantitative data, it may be wise to conduct an industry, financial statement, DCF, ratio, or macroeconomic analysis.
- Fundamental analysis also considers qualitative factors such as a company’s management and its track record of delivering value to shareholders. Other qualitative factors include the competitive landscape, regulatory landscape, brand value, and broader industry or demographic trends.
Connected Economic Concepts
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