Beginners' guide to fundamental analysis
Fundamental analysis seeks to identify markets that are under or overpriced, by considering the economic and financial factors which affect their intrinsic value. Learn about fundamental analysis and how to use it in your trading.
What is fundamental analysis?
Fundamental analysis is a means through which a trader assesses the intrinsic value of an asset by taking a holistic approach to the markets. As a result, a fundamental analyst might look at a range of factors as a basis for their investment decisions.
These factors can be macroeconomic, including:
- The health of an entire country’s economy
- Which sectors are doing well in that economy
- News reports and international politics
- How competitive a particular market is
They could also be microeconomic, such as:
- Supply and demand
- Labor economics
- Costs of production
Fundamental analysis can be applied to many markets – including forex and commodities – but for this article, we’ll predominantly look at shares.
What’s the importance of fundamental analysis?
Fundamental analysis is important because it can be used to assess the intrinsic value of a company, and therefore whether it is under or overvalued. This can help traders decide whether they wish to open or close a position.
Intrinsic value refers to the actual (or ‘true’) value of a stock, rather than its current market value. For instance, if a stock was overpriced on the market, it could be susceptible to a rapid decline at some point in the future.
Equally, if the stock was undervalued on the market, it could be an opportunity for a trader to get in early and realize a large profit once the market value is adjusted to reflect the intrinsic value.
To determine whether a stock is trading at its intrinsic value, individuals could look at a company’s management team, financial statements or the company’s market share.
What is the basis of fundamental analysis?
Fundamental analysis looks at the factors which separate one company from another, enabling traders to assess what that company does better than others in its sector. For instance, the difference for one company’s success over another could be its executive team. If this were the case, fundamental analysts might look at the following before opening a position:
- What is the educational background of each executive?
- Where have they worked previously?
- What relevant experience do they bring to their role?
- Have they had any notable achievements (or failures) previously?
Other factors which form the basis of fundamental analysis include the company’s profit and loss statement, cash flow statements and income statement. A basic example of a profit and loss statement can be seen below.
A trader would use this statement to assess how the company is being run, and whether it is capable of yielding a profit. It is with this analysis that the trader might decide to open or close a position, depending on how profitable they perceive the company to be.
Fundamental analysis works best when a range of different factors have been analysed, from both a macro and microeconomic viewpoint. This is because, unlike technical analysis – which looks primarily at quantitative data – fundamental analysis has the luxury of looking at a combination of quantitative and qualitative data to assess a company’s profitability.
How to use fundamental analysis
Fundamental analysis can be either quantitative or qualitative. As a result, it can be used to analyse the sector, the industry, the company or the market.
- Quantitative fundamental analysis looks at a company’s viability as an investment opportunity in terms of its numerical strengths – profit and loss statements, cash flow statement and market share
- Qualitative fundamental analysis looks at factors which affect the character or quality of the company. Examples would be brand recognition, senior management or customer satisfaction
The fact that fundamental analysis can be both quantitative and qualitative is a huge benefit, as it means that traders can base their decisions on more than what the numerical data is showing. As has been seen with companies like Twitter – which didn’t turn a profit until quarter four (Q4) 2017 – numerical data is not always the sure-fire way of assessing whether a company has the potential to realize a profit.
Instead, a trader needs to look at qualitative factors which can show whether the company has something unique – or is being run in a particular way that has the potential to yield a profit in the years to come at the expense of incurring a loss in the immediate future.
Fundamental analysis vs technical analysis
Rather than looking at the bigger picture, technical analysis is concerned with the historical price movements of an asset. By looking at charts and using patterns to assess the behavior of market participants, technical analysts hope to predict an asset’s future price movements.
Technical analysis relies heavily on chart patterns and moving averages. As a result, technical analysis requires an in-depth knowledge of – and sufficient aptitude at identifying – chart patterns and what each pattern might mean for the future price movements of a stock.
On the other hand, fundamental analysis requires less specialist knowledge of technical indicators. Instead, fundamental analysts should have an in-depth knowledge of their chosen market and sector so that they know how to quickly and accurately identify viable companies based on news reports, financial statements or changes in company leadership.
Fundamental analysis summed up
In summary, fundamental analysis is concerned with the wider picture; it seeks to understand why and how extrinsic factors impact the financial markets. In a way, fundamental analysis is the study of how human behavior affects the markets, because it is through fundamental analysis that we learn how human decisions and leadership can cause an asset to rise or fall in value.
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