Fundamental analysis in accounting and finance terms is a method to assess the intrinsic value of a company by analyzing various macroeconomics and microeconomics factors. A macroeconomic factor is, for example, the state of the economy that the world, a country, or an industry has, and microeconomics factors are for example the management of company effectiveness. Overall, the intrinsic value should be compared to the current market price to help investment decisions.
Unlike technical analysis, which focuses on the prediction and identification of the price movement, fundamental analysis points to the true value (intrinsic) of a stock. This is happening because stocks tend to be overvalued, undervalued, or fairly valued and investors need to know the true value to compare it and conclude a more formed decision.
Three types of analysis can be used in the stock market or Forex market are:
Fundamental Analysis embodies three main parts:
For example, investors and analysts that use fundamental analysis need to have some knowledge. It requires knowledge in reading a financial statement, net income statement, and valuation techniques.
An unemployment rate can affect a country’s economy and ultimately the monetary policy. You have to be able to understand how an increase in the unemployment rate will affect stocks and vice versa.
For example, when a specific industry is being affected for a specific reason, but the rest of the industries are not being affected it is part of industry analysis. Industry examples are energy, technology, healthcare, consumer products, aerospace, etc.
This year’s pandemic made the technology sector very profitable due to the whole world’s lockdown. People worked from home instead of going to the office, people had meetings via Zoom, which is why this stock went up while the rest were falling. Besides, the transportation sector did very bad since people did not need to move around that much.
For example, when a specific company is facing some changes whether in management, or structure, production and more is a company analysis. It will not affect the economy and it will not affect the sector that the company is operating in.
If Walmart decides to change the CEO, the company will go through some changes, but it will not cause an economic matter. The financial statement of the company and the income statement will be affected.
A top-down approach is when the investor starts analyzing the economy as a whole. To do so, they take various macroeconomic factors such as inflation rate, interest rates, and GDP level. This helps investors and analysts understand where the economy is standing, and which direction will the economy follow in the future. This allows them to understand how the industries and sectors will be affected and enable better investment opportunities.
After doing the necessary analysis they select specific stocks in the industries with the most potential to identify the best investment in a specific company.
The bottom-up approach works in the exact opposite direction. Instead of analyzing the economy first, then the sector, industry and finally the company, they start from the company. Investors and analysts who use this type of approach base their thinking on the fact that a stock can perform much better than the overall industry. For example, let’s assume that the technology industry is not doing well but Microsoft that is part of that industry is performing very well.
The bottom-up is mainly examining microeconomic factors solely based on a company’s performance. Such as earnings, net income, expenses, revenues, future growth, and EPS.
As mention in the beginning, investors will try to use their educated opinion to evaluate a stock’s intrinsic (true) value. An analyst or investor is working to create a model that will determine the estimated value of a company’s stock price based on available information to the public. This value can only be an estimate of what the investor believes that the share price is worth compared to the share price the company is traded at.
If investors or analysts decide that a stock’s real value should be $30 and the actual price of the stock is $20, they will most probably buy the stock. This gives them a sense of an undervalued company that has more potential to grow than they already established companies. On the other hand, if investors and analysts decided that a stock’s real value should be $20 but the stock is traded higher, the stock is probably overvalued. They will recommend a sell position if trading CFDs. If they already hold the stock, they will probably sell it since the stock will normally bounce back to its true value.
Fundamental analysis is considered to be the exact opposite of technical analysis. Technical analysis does not involve studying the intrinsic value of the stock. Instead, traders will use it to forecast the price direction on a given stock chart. They use historic data and volume to predict the price movement since they believe that history tends to repeat itself!
Fundamental factors can also be separated into two categories.
Qualitative information is related to subjective judgment and not quantitative information. Ex. Management expertise, industry cycles, etc.
Quantitative information is related to numbers and things that can be measured.
Analysts that work on qualitative factors of a company will look at:
The business model explains what the company does. If the company is selling services, is it actually making money through that? Is it making the best possible income out of it? Is it spending too much on unnecessary things? All these are very important to evaluate a company’s structure.
Competitive advantage is looking at a company’s competitors by asking:
What is this company doing better than competitors? What will put them ahead of rivals? When a company achieves a competitive advantage, investors will also be rewarded.
Some believe that the management of the company is the most important thing. Think about it and it makes sense. Even a company with the best business model can go wrong if the management does not know what they are doing. On the other hand, if the business model is not so good but the management is transparent enough it can find ways to put the company ahead in the game.
Analysts that work with quantitative data will look at:
Financial statements are also referred to as balance sheets. It represents the company’s assets, liabilities and equity. The overall idea of a balance is that assets equal liabilities and shareholders’ equity.
Assets represent what the company owns, or controls and liabilities show the total value of the financing that was used in order to acquire these assets. This is why a balance sheet needs to always be balanced, thus the name. In other words, liabilities represent debt that the company needs to pay off. These statements need to be submitted every end of the year or quarterly.
The income statement represents the company’s performance in terms of revenue and expenses. The end result is to show how profitable the company was during this year and show where most expenses went to.
Fundamental analysis is a very important factor to know before owning a stock. You might think that a company is good to invest in but when you analyze it you might find that it is not profitable and it does not have assets that can support liabilities.