The Basics of Fundamental Analysis
Fundamental analysis strives to determine the intrinsic value of an asset through the analysis of a business’s financial health and statements, but also broader factors like the state of the economy and industry the business operates in. Investors regularly employ fundamental analysis when attempting to identify attractive investment opportunities.
What is Fundamental Analysis?
Preferred by some investors and analysts, the fundamental analysis attempts to evaluate the potential of a business based on its financial and non-financial data. It is one of the key metrics investors look at to dive deep into the company’s growth prospects. As such, it is one of the most common methods used to find good investment opportunities.
Fundamental analysis is a long and thorough process. Investors usually begin conducting this analysis by examining macroeconomic factors including general economic data and the current trends in a particular industry, but also more detailed aspects such as companies’ strategic efforts, business policies, management, and more.
When it comes to stocks, investors that rely on fundamental analysis commonly review data like a company’s revenue, profit, return on equity (ROE), profit margins, and other important metrics that help determine a company’s intrinsic value, sometimes also referred to as ‘real value’. Note that all of this data can be found in a company’s financial statements.
Fundamental analysis is also often viewed as the opposite of technical analysis, which instead relies on the volume and price data of security to identify appealing investments and potential entry and exit points.
How Does Fundamental Analysis Help Investors?
The primary objective of fundamental analysis is to determine the intrinsic value of a security. If an investor understands that a security’s intrinsic value is above its current market price, it means that the security in question is undervalued and is typically a good investment opportunity. In that case, the investor would purchase the security and hold it until it reaches its intrinsic value and then sell it to take profits.
On the other hand, if an investor understands that the security’s intrinsic value is lower than its current market price, it would mean that the security is overvalued and in that case, the investor would usually avoid buying it.
Therefore, fundamental analysis is a commonly used method that helps investors mitigate investment risks and make data-driven decisions. Most Wall Street analysts and investors prefer fundamental analysis to technical analysis, but there are those that have had success in implementing both.
Bear in mind though that fundamental analysis is more useful for long-term investing, rather than day trading or other short-term investing strategies. The main reason for this is that it can sometimes take up to months or even years for security to reach its intrinsic value, or not reach it at all.
That’s why investors who rely on companies’ fundamentals to make an investment plan hold that investment for a couple of months or years, hoping that the company will reach the expected growth in the future.
Types of Fundamental Analysis
There are numerous fundamental factors analysts and investors look at when conducting their analysis, from the general health of an economy to corporate earnings. These factors are grouped into two big categories known as quantitative and qualitative fundamental analysis.
As their name suggests, quantitative fundamentals represent measurable numbers and characteristics of a company. Thus, the single most important source of quantitative fundamentals is a company’s financial statements including earnings, revenue, and assets, among others.
On the other hand, qualitative fundamentals are not as concrete and relate more to the nature of a company’s business. These could be the company’s management members, patents, technology, and similar.
The main goal of quantitative fundamentals is to provide investors with something of value that they can compare with the security’s current price, bringing them a step closer to determining its intrinsic value.
However, a key downside of quantitative analysis is that it doesn’t account for aspects that are not tangible such as the value provided by the company’s leadership or its regulatory challenges. This is where qualitative analysis comes in to evaluate the non-number side of the company.
Even though they’re somewhat more challenging to measure, the qualitative fundamentals are just as important. Because they are not tangible, these factors are mostly subjective and represent different tailwinds and headwinds the company faces. However, it’s important to say that some qualitative fundamentals leave a larger impact than others, and gauging their extent is often a key part of qualitative analysis.
Some of the more specific examples of qualitative factors can be legal risks that could hurt a company’s reputation, management revamps and their potential impact, a company’s relationship with its partners and suppliers, customers’ satisfaction or discontent with a company’s services, and similar.
Many believe that the most effective way to perform the qualitative analysis is after analyzing the quantitative factors. This is because the end result of the qualitative analysis can provide more perspective to the quantitative part, allowing investors to make better, data-backed choices.
Pros and Cons of Fundamental Analysis
One of the key advantages of fundamental analysis is its broader approach to evaluating a company. As we have already mentioned above, the fundamental analysis covers everything from broader factors like the general health of an economy and the market to more specific factors such as a company’s financial statements. Thanks to this, the fundamental analysis ignores personal biases, providing investors with an unbiased, reasonable evaluation.
Furthermore, the fact that it covers different areas and factors also makes fundamental analysis particularly useful for long-term investors. This approach allows investors to identify a company’s underlying strengths which could show its true potential in the long run and ultimately reach its intrinsic value.
As you might have guessed, fundamental analysis can be very time-consuming, especially when compared to technical analysis. The main reason for this is that analyzing fundamentals means covering dozens of macro and micro factors that are important to the performance of a company.
Thus, if an investor needs to quickly decide his next move, the fundamental analysis might not be the best choice as it would take a certain amount of time to cover all the factors, which could ultimately lead to late decisions and lost opportunities.
Conducting fundamental analysis is easier said than done given that one needs to evaluate so many different factors and areas at the same time. Moreover, a part of fundamental analysis is subjective which could also become a disadvantage as one can combine personal experience and biases to evaluate the numerous qualitative factors.
Fundamental analysis is one of the most commonly used methods to evaluate the financial health of a company, its industry, as well as the broader economy. Its primary goal is to determine a company’s intrinsic value, also known as the ‘real value’. While it is often preferred to technical analysis, it does not mean fundamental analysis will be always successful because market prices depend on a number of different factors.
For that reason, investors and analysts often combine fundamental, technical, and quantitative analysis to assess the potential of a business and its growth prospects.