What is fundamental analysis and how does it work?

Fundamental analysis is a method used to evaluate the value of a financial asset, such as a stock or bond, by examining the underlying factors that can affect its price. It involves looking at both quantitative and qualitative aspects of the asset to determine whether it is overvalued or undervalued.

There are two core assumptions of fundamental analysis. The first is that stock markets may be inefficient in the short run but efficient in the long-term, meaning share prices will eventually reflect a company’s genuine performance over time. The second premise is that scrutinizing publicly available information such as financial reports, statements, industry analyses and economic indicators allows an analyst to estimate a company’s true worth.

In this article, we will examine what fundamental analysis is and some key factors that analysts consider when evaluating an instrument for investing. If you would like to start investing, you should make sure you understand key principles of the markets from how they move to how to trade. You should also be prepared to face losses and never risk more than you can afford to lose.

How does fundamental analysis work?

Fundamental analysis involves examining various financial and economic factors that can provide insights into a company or security’s intrinsic value. This includes considering both macroeconomic variables like broader industry trends and GDP, as well as microeconomic company-specific metrics.

Key financial documents

Key financial documents are especially important to analyse when conducting fundamental analysis for stocks. Income statements, balance sheets, cash flow reports and annual filings with agencies help give a picture of a business’ profits, assets, liabilities, cash generation and any significant events. Past performance revealed in these records can also help provide context for potential future performance.

Income statement

Also known as the Profit and Loss Statement, the income statement provides a summary of a company’s revenues, expenses, and net income over a specific period. It helps analysts assess the company’s profitability, revenue growth, and cost management.

Balance sheet

The balance sheet provides a snapshot of a company’s assets, liabilities, and shareholders’ equity at a given point in time. It helps analysts evaluate the company’s financial position, liquidity, and leverage.

Cash flow statement

This statement outlines the cash inflows and outflows from operating activities, investing activities, and financing activities. It helps analysts understand the company’s cash generation, liquidity, and ability to fund investments and debt repayments.

Competitor landscape

Next, competitive dynamics and where an industry is in its cycle are also valuable to survey. By evaluating demand factors and competitors as described, a fuller picture of opportunities and risks for a company emerge. Some aspects that fundamental analysts may consider include competitors’ financial performance, their market share and positioning, growth prospects of the overall sector, pricing strategies, and operational efficiency.

From reviewing the competitor landscape, analysts can also assess the company’s competitive advantages, market share, and differentiation strategies within the market. This includes looking at its pricing power, product portfolio, distribution channels, and customer loyalty. Comparing the company’s strengths and weaknesses to its competitors to gauge its relative position in the market can also help.

Macroeconomic factors

Broader economic conditions and trends provide the backdrop for projecting demand and costs of the company, which will lead to rises and dips in the evaluation of their share price. Analysts factor in macro metrics like GDP growth, interest rates, inflation, and unemployment of the country in which the company is based to gain insight into how the economy is doing. This can potentially affect how the sector and the desired instrument performs.

Management integrity and capability

Thirdly, management competence and strategic plans play a role as well. How capable a management team is and their strategy to navigate challenges can impact investment outcomes. Fundamental analysts will therefore look at qualitative aspects like a company’s corporate strategy, business model, brand strength, customer retention levels, and operating efficiencies.

Conclusion

Fundamental analysis is a powerful tool that allows investors to go beyond the surface-level market trends and understand the underlying factors that drive a company’s success. It provides a systematic framework for evaluating the financial health, growth potential, and competitive position of a company.

By thoroughly analysing financial documents, assessing the competitor landscape, and understanding industry dynamics, fundamental analysts aim to identify stocks that are trading below their intrinsic value, presenting opportunities for long-term capital appreciation.

Moreover, fundamental analysis serves as a risk management tool by helping investors identify potential red flags and warning signs. By examining a company’s financial statements, analysts can identify high levels of debt, deteriorating profitability, or other indicators of financial distress. This allows investors to make more informed decisions and avoid potential pitfalls.

While fundamental analysis does not guarantee investment success, it provides a solid foundation for making investment decisions based on objective data and analysis. By focusing on the underlying fundamentals of a company, fundamental analysis enables investors to make informed judgments about the long-term viability and growth potential of an investment.

Categories: