Fundamental Analysis

Fundamental analysis (FA) refers to the process of studying any security's intrinsic value with the object of making profits while trading in it. The primary purpose of fundamental analysis is to determine whether the security or stock is undervalued or overvalued and thereby make an informed decision to buy, hold, or sell it in order to maximize the potential for gains.

Fundamental Analysis in simple terms in the art of evaluating any business to its basics and getting an accurate picture of how financially healthy and sustainable it is. It involves studying a company’s potential for future growth by considering various micro and macroeconomic factors. This analysis assists in deriving at an intrinsic value of stock that aids investment decisions.

• Fundamental analysis is the method to determine the intrinsic value of any security or stock by comparing key ratios to find out a company's financial health.
• The purpose of conducting fundamental analysis is to identify investment opportunities and benefit from them.
• There are two types of fundamental analysis - Qualitative and Quantitative. Qualitative is inclined towards goodwill, market conditions, brand value, and company performance. In contrast, the quantitative analysis is statistically driven.
• Fundamental analysis is often compared with technical analysis. While the former focuses on understanding all factors affecting a company to help stock selection, the latter involves studying stock price movements to time buying and selling of stocks.

Fundamental analysis assesses a company’s potential based on financial and non-financial data to obtain the fair value of its security, stock, bond, or derivative. It is a powerful tool for investors and stakeholders to understand the growth prospects and financial health of a company. Therefore, it is one of the most effective ways to evaluate investments.

It involves examining every aspect of a company’s operations through its balance sheet, past performance, financial reports, even market goodwill, management, and consumer behavior to arrive at the intrinsic value of its securities.

The analysis begins from macroeconomic factors such as the economy and industry performance and goes down to microeconomic factors like management, strategic initiatives, and business policies. Note that the analysis can also start at the microeconomic level and then move to macro components.

On conducting Fundamental analysis, if an investor deduces that a stock's intrinsic value is greater than its market price, it means the stock is undervalued. In that scenario, the investor buys such stock and holds it until the market price reaches the intrinsic value. Then, the investor makes a sizeable profit on selling at intrinsic market price.

Similarly, an investor may decide to sell or refrain from buying an overvalued security. Being overvalued means that the stock's intrinsic value is less than its market price. Thus, FA may guide investors to manage risks and make informed investing decisions by ascertaining the intrinsic value of a stock. Financial ratios calculated using data from the financial statements are the primary tool of FA.

Blindly investing in stocks without conducting FA may result in major losses, as revealed by the dot-com bubble in 2008-09. Thus, investors should employ fundamental analysis to make conclusions about companies and their securities. However, in practice, it should be used in conjunction with another process called technical analysis.

The technical analysis involves closely observing the stock price movements to predict the future and make investment decisions. It depends on past trends, stock charts, and price history to look for stocks that may perform better in the long run. Hence, technical analysis can be called the fundamental analysis of the stock market.

FA is used in many areas and is classified into two types -

#1 - Qualitative analysis

Qualitative analysis involves the study of a company's goodwill, consumer behavior, demand, and company recognition in broader markets. It aims to unearth answers to questions like how it is perceived, how management decisions or announcements create a buzz in the market, and how it is different from its substitutes. In addition, its brand value and other common factors depict its socio and economic position in the market.

#2 - Quantitative analysis

Quantitative analysis is inclined towards statistics, reports, and data. It is solely based on its financial statements, quarterly performance, balance sheets, debt, cash flow, etc. It involves analyzing numbers, ratios, and values to understand the price of the shares and the company's overall financial health.

Two approaches are generally used in performing FA of a company:

#1 - Top-down approach

In this approach, experts start from macroeconomic factors assessing the economy and industry first. Then, they come down to market conditions and ultimately to evaluating a company's progress, management, and other microeconomic factors.

#2 - Bottom-up approach

This approach is the vice versa of the top-down course. It starts with studying the company, digging up its record and performance, and then slowly moving upwards to macroeconomic factors like industry conditions and a country's economy.

A step-by-step execution is initiated to perform a fundamental analysis of stocks, securities, or companies. The critical aspects of it are -

1. Economic, industry, and company analysis

FA considers the industry's structure, economy, industry dynamics, aspects of broader markets, and all the other macroeconomic factors.

The experts study the products, commodities, services rendered, and substitutes available along with cost structure and revenue model and composition and the company's future goals and objectives.

2. Evaluation of financial statements

Every company report is studied closely - the balance sheets, income statement, cash flow, price to book value of equity, the net market value of assets, and other vital ratios with revenue.

3. Study of non-financial aspects

Besides a company’s financial statements, non-financial matters like competition, management, business policies, etc., also influence a company. Therefore, in the FA of stocks, experts also look for factors that can influence or undermine the company's performance.

4. Use of FA tools

Investors and analysts use financial ratios to determine a company’s financial standing. It is used along with the available financial data from past reports to measure future growth, stability, and investment.

5. Recommendation

Based on the study, investment decisions are taken. Analysts advise investors to buy, sell, or hold security after carefully assessing its intrinsic value and financial stability.

The disintegration of the auto-giant General Motors stocks in 2009 is one of the glaring examples of the risks of ignoring fundamental analysis. Unfortunately, investors who missed the fundamentals bore the brunt of the massive collapse of the GM stock that led to GM filing bankruptcy protection.

A 2018 research study by Raúl Navas, Ana Paula Matias Gama, and Sónia R. Bentes investigates the significance of FA in understanding the worth of a company. The study concludes that the investors can use FA scores to create a portfolio that is likely to yield them remarkable returns within a year or two. The research also adds to the understanding of mispriced stocks in the European capital market.

This has been a guide to Fundamental Analysis. Here we discuss the meaning of fundamental analysis along with its types, steps, & examples. You can learn more about financing from the following articles –

• Fundamental Analysis vs Technical Analysis
• Financial Analysis
• Ratio Analysis