What is Fundamental Analysis: Definition, Types & Examples
What is Fundamental Analysis: Definition, Types & Examples
17 October 2022
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What is Fundamental Analysis: Definition, Types & Examples
The forecasting of financial markets is a complex process that is based on several tools and various indicators. Fundamental analysis is one of the most effective tools for studying the situations in the financial markets and with individual assets. This article will help you learn detailed information about fundamental analysis, its types, examples, and applications.
What is the Fundamental Analysis?
Fundamental analysis is a method for predicting the market value of stocks and other assets, based on data analysis. The analysis is based on data such as a company’s financial performance (revenue, EBITDA, net income, book value of the company, liabilities, cash flow, amount of dividends paid, etc.), industry performance of the asset, upcoming and past financial news and publications, and market data.
In addition to this, fundamental analysis is based on economic and political news that can influence the value of certain company stocks or assets, including commodities, indices, currency pairs, precious metals and cryptocurrencies.
As a rule, fundamental analysis is complemented by technical analysis, which is also one of the main methods for predicting the value of financial instruments in the markets. However, you can use an investment strategy based on only a method. The results will help determine the prospects of the industry and predict the value of the analyzed asset for the period from a few hours to several years.
What are the Basics of Fundamental Analysis?
Fundamental analysis is price forecasting based on analysis of the economy as a whole, the state of the industry and the company’s market performance. It works better in the long term-weeks, months and years, unlike technical analysis, which can be applied even at intervals of a few minutes. Therefore, an investor should resort to fundamental analysis when planning a portfolio for the long term-weeks, months and years.
The analysis includes three stages:
Company or industry performance.
Each stage is based on different approaches and multipliers. For example, macroeconomic indicators are the country’s GDP, unemployment rate, import and export volume, key rates of central banks and news that can affect the value of assets.
Industrial analysis is based on an in-depth analysis of an industry (industry, raw materials, retail, agriculture, IT, and others). Company metrics include many multiples (P/E, for example) to assess financial prospects.
All of these help make predictions about whether the value of the chosen financial asset will rise or fall.
What are the Different Types of Fundamental Analysis?
There are two types of fundamental analysis: quantitative and qualitative. Quantitative analysis focuses on publicly available financial data of a company, such as revenue, price-to-earnings ratios, return on equity and others.
Qualitative fundamental analysis focuses on less tangible company or market data. For example, the quality of business management, brand awareness, intellectual property, and more. Because these two types of fundamental analysis are very different, it’s hard to say which one is more valuable. Therefore, investors use a combination of both to get a fair market value for target investments.
We have prepared for you a comparative description of each of the two common types of fundamental analysis. Let’s take a look at it.
Qualitative analysis is more subjective because it relies on unquantifiable data. For example, management skills, industry competition, the state of the economy as a whole, and many other macro and microeconomic factors that affect business performance. Below, we have detailed some key pieces of information that we must consider when performing this type of analysis.
A company’s business model is one of the factors in a qualitative analysis of a company. Therefore, investors often analyze the direction in which the business of the company in which they want to invest is moving. The business model is based on the prospects, goals, technologies used, innovations, patents, and tools. The more thoughtful the business model, the more likely the company’s stock price will continue to rise.
The long-term success of a company depends to a large extent on how successfully it can compete. A powerful competitive advantage, such as Coca-Cola (because of its brand) or Microsoft (because of the popularity of its operating system). This creates a foundation around the company’s business that prevents competitors from taking customers away from it. If a company has a competitive advantage, its shareholders can reap the benefits of that success over time. Evaluate which companies have an advantage and unique technology. For example, Apple, 3M, Samsung and many other companies have patents and their products cannot be copied. This promises higher financial potential, which is very important in fundamental analysis.
Some believe that management is the most essential factor to study in investment activities. It makes sense – even the best business model is doomed to failure if the company’s leaders fail to properly implement all strategic plans. It is quite difficult for small investors to meet in person and evaluate management, but it is possible to study the company’s website and the track record of the top management and board of directors. Pay attention to their past successes and failures, and whether they are buying or selling stock in their company.
Corporate governance is a set of procedures and rules within the company that define the relationship between management, the board of directors and shareholders. It is spelled out in the founding documents and various regulations. You probably want to deal with an ethical company that does business openly, honestly and efficiently. Pay particular attention to how much the company respects and values shareholder rights and interests. Make sure that communication with shareholders is clear, understandable, and open. This will help you assess the quality of corporate governance, which is part of the qualitative analysis methodology.
Quantitative analysis makes it possible to assess the current and projected state of the market or the value of an asset based on precise figures. Specifically, this approach uses the financial statements of publicly traded companies as the primary source for all sorts of quantitative data about a company’s business. Many investors use this data to make investment decisions. The three most important reports for investors and traders are the income statement, the balance sheet, and the cash flow statement. Other quantitative indicators such as key rate, GDP, exports and imports, deficit/surplus, demand and more should also be analyzed.
Below, we describe in more detail the three components of quantitative analysis.
The balance sheet gives a picture of the state of the business at a certain point in time, but the profit and loss statement shows how the company has been doing for a certain period of time. Theoretically, the balance sheet can be done on a specific day or month, but public companies provide it based on quarterly and annual results.
A profit and loss statement gives information about a business’s revenues, expenses, and profits for a certain period.
The balance sheet reflects the assets, liabilities, and equity of a company at a particular point in time. The balance sheet is so called because:
Total Assets = Liabilities + Equity
The assets on the left represent the resources that the company owns or controls at the current point in time. These can be cash, equipment, real estate, finished goods balances, etc. The right side of the equation reflects the total financing that was used to acquire these assets. Financing can be in the form of debt or equity. Debt is repayable, while equity is the funds that owners have invested in the business, including retained earnings from performance in previous years.
A cash flow statement shows the inflows and outflows of money over a period of time. Typically, a cash flow statement focuses on the following:
Cash from investments: cash used to invest in assets as well as proceeds from the sale of businesses, equipment, and other assets.
Cash from financing: cash expended or received as a result of issuing securities or borrowing.
Operating cash flow: cash generated from the day-to-day operations of a business.
The cash flow statement is important because it is difficult for a company to manipulate its cash flow. Doubtful companies often manipulate earnings figures, but it is very difficult to misrepresent the amount in a bank account. For this reason, many conservative investors use the cash flow statement as the most accurate indicator of a company’s state of affairs.
How to Do Fundamental Analysis?
Fundamental analysis consists of different methodologies, but two key approaches should be studied to better understand this type of forecasting: the top-down approach and the bottom-up approach. Let’s take a closer look at their features and differences.
A top-down approach means that a financial markets participant begins his or her analysis by examining the overall economic environment in search of the most attractive market with the best prospects. The task of this step is to identify the industry with the best outlook. Accordingly, the next step is to select a company or asset from the most promising industry. The analysis is conducted by studying macroeconomic indicators and the geopolitical environment. At the final stage, the conditions of the most favorable investment are determined: the amount of investment and term.
This methodology allows more factors to be taken into account than in traditional fundamental analysis of the market or an individual asset.
An alternative approach called bottom-up is also popular. The first step in this methodology is to choose one or more companies in order to analyze their macroeconomic indicators. After deciding an asset, it is necessary to make sure of the prospect of further price growth. This involves analyzing the market as a whole as well as the macroeconomic indicators of the industry.
Every investor or trader chooses a methodology that suits him/her best. Each approach has supporters and opponents, so there is no single correct approach to the fundamental analysis.
Fundamental Analysis Examples
Here are some examples of fundamental analysis.
Example №1: Twitter published its annual earnings report, which recorded a 10% increase in profits (EBITDA) with a positive outlook.
Financial market participants evaluate such news and profit forecasts positively, so immediately after the publication, the value of the company’s shares began to rise. In this case, the fundamental analysis was based on the company’s public financial reports.
Example №2: Meta received a P/E ratio of 5 on the eve of the quarterly report.
The P/E ratio (price to earnings) shows the ratio between a company’s share price and earnings. It is an important indicator in fundamental analysis. It shows undervalued and overvalued companies in relation to the company’s potential earnings, as well as the payback period and proportionality of earnings.
A P/E score of 5 means that an investor will make $1 profit on an investment of 5. This is a very good payback of 20%. Accordingly, such an investment can be very profitable.
Example №3: Shares of Levi Strauss rose 3.9% momentarily to $16.43.
The value of the securities rose after the publication of the company’s second-quarter reports. It reported net income of $50 million and adjusted net income of $117 million, up from $93 million in the second quarter a year earlier.
Levi Strauss also increased its quarterly dividend by 20%, to $0.12 per share, which sparked demand for the stock.
You can interpret these situations in different situations, but they reflect how fundamental analysis and forecasting works in real-world conditions.
Importance and Benefits
Fundamental analysis allows us to evaluate the performance and financial stability of a company. Advocates of fundamental analysis primarily analyze the business of issuing companies and the market situation. This method allows you to compare the key players in the market with each other, and only after that you can invest in a company that can outperform its competitors and take a leading position in the market.
Fundamental analysis reflects the value of assets in perspective and, as a rule, it differs from the actual value. It happens that a security is overbought or, on the contrary, undervalued by the market. Accordingly, technical analysis is unable to reflect such a large amount of useful information in choosing assets for an investment portfolio.
This is the main advantage of fundamental analysis.
Fundamental Analysis vs. Technical Analysis
In predicting the value of stocks of companies and other financial market assets, there are mainly two types of analysis.
Fundamental analysis allows us to understand whether a company’s stock or another asset is currently undervalued or overvalued. Based on this, investors make a choice in favor of certain assets for investment.
Technical analysis is used in other scenarios. This methodology allows one to determine the best moment to make transactions for the selected asset. Accordingly, fundamental analysis is more used for long-term investments, while technical analysis is used for short-term speculative transactions on the market.
In practice, the combination of these two methods is often used. These methods complement each other well, and their simultaneous application provides a complete picture and understanding of the overall market situation.
The Concept of Intrinsic Value
Intrinsic value is the projected value of an asset based on fundamental analysis. It is believed that intrinsic value may differ from the market price of a financial instrument. Investors and traders focus on the intrinsic value of an asset in their forecasts, betting on the appreciation or depreciation of the asset (shares, currencies, indices, precious metals and others).
Most often, this methodology is applied in valuing a company’s stock based on its current and projected financial performance. There are several approaches and formulas used in the concept of calculating intrinsic value.
Each intrinsic value methodology is based on evaluating factors such as P/B, P/S, P/E, EPS, ROE, EBITDA and more.
Criticisms of Fundamental Analysis
Some financial market participants criticize fundamental analysis because of several of its drawbacks:
Large amount of information to analyze;
High speed of decision-making (some data is relevant in hours);
Subjectivity of some factors, including news, political decisions and the like;
The analysts’ margin of error and the experience needed.
Therefore, it is recommended to use fundamental analysis in addition to other methods of forecasting.
The Bottom Line
There are many external economic and political factors affecting the value of financial assets, whether they are currencies, indices, stocks, or anything else. Fundamental analysis is one of the most popular methodologies for predicting financial markets. You will need to use a variety of tools and study a lot of information to be successful at it. This article will help you find the right path in analysis to build your remarkable and profitable investment strategy.
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