What Is Fundamental Analysis? (With Types And Importance)
Updated 30 September 2022
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With growing inflation, investing and trading are not exclusive to the wealthy, but have become a common financial tool for individuals as a source of additional income to sustain increasing living expenses in the long run. These activities require some level of training and understanding of how the market works and how stock prices rise and fall. Investors and traders often use fundamental or technical analysis to make their decisions. In this article, we discuss what fundamental analysis are, their types, importance and explain how to do it.
What Is Fundamental Analysis?
Fundamental analysis is a study of certain factors, such as financial statements, external factors, news, events and trends in the industry to determine the true value of a stock. Usually, it takes some time for the true stock value to change, depending on these factors. This method can help you determine the value of a company and its potential in the future. It considers both micro-and macroeconomic factors. These values may differ from the value at which the stock is being traded in the market.
The prevailing economic conditions also play a major role in determining the stock values and prices. During an economic depression, prices can fall drastically. On the contrary, when there is an economic boom, prices may rise exponentially, causing the investors to make massive gains from their investments. Industry trends can also affect the prices of certain commodities along with their stock values. For example, if people become more environmentally conscious and start moving to electronic vehicles, motor companies that produce fuel-driven vehicles may suffer and their stock prices can drop.
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Types Of Fundamental Analysis
There are two main types, based on the approach or what aspects are being evaluated to derive a value. These are qualitative and quantitative analysis. Within these, there are two other approaches to fundamental analysis, namely top-down and bottom-up approaches. Here are the different types of fundamental analysis:
Qualitative fundamental analysis focus more on the subjective and unquantifiable aspects of an entity to determine its stock value. Rather than analysing the quantifiable data, it studies factors like the brand value, employee satisfaction, how efficient or experienced the management is, customer feedback and other details.
It may not possible to measure these factors in numeric terms, but they can indicate the overall position and potential of the business in the market. Using qualitative analysis alone may not give the most accurate prediction. Combining it with quantitative analysis may be a better strategy.
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A quantitative analysis considers the quantitative or numerical factors to estimate the value of a stock. It is primarily based on statistics and mathematical calculations. Quantitative analysis is useful in almost any field that comprises any kind of quantitative data, statistics or figures that analysts can study to draw conclusions or make behavioural predictions. Even governments and banks employ quantitative analysis to make informed economic and financial decisions.
The top-down approach begins by looking at the broader economic variables that may influence the prices or values of stocks. These may include the current gross domestic product (GDP), environmental or geopolitical events. These variables can affect the monetary conditions of the entire economy of a country at large, rather than just a particular sector, company or business. For instance, a natural calamity can hinder the production of goods or slow it down. If the government introduces new policies to support and encourage entrepreneurship, it can have a positive effect by allowing new businesses to continue operations.
After considering the macroeconomic variables, the analyst may scrutinise the specific company's charts, data or other factors that help predict stock prices. They may combine qualitative and quantitative analysis to reach a more accurate conclusion regarding its value. When there are overbearing macroeconomic variables, it is ideal to use the top-down approach.
The bottom-up approach is the exact opposite of the top-down approach. It starts by studying the specific details and internal factors associated with the company or business. The microeconomic variables have precedence over the macroeconomic ones. These microeconomic variables may include customer base and satisfaction, qualified human resources, suppliers and distribution channels, competition, investors and publicity. For example, customers play a crucial role and defining the success of a business. If there is enough demand or customers for a product or service, then the business is likely to succeed.
Competition can also be a powerful indicator of the future prospects of a business. If there is low competition, it might mean that the demand in the market or the number of competitors is low. Having a lot of competitors may mean that there is a huge market for the product, but it can also mean that there is a sufficient supply of the product in the market, making it difficult for a new or a lesser-known brand to penetrate the market. This is why it is important for the analyst to look at these factors from all angles before making a prediction.
Importance Of Fundamental Analysis
Fundamental analysis are one of the most reliable methods for making long-term predictions. Analysts often use this, along with technical analysis, to form better financial and investment decisions. Technical analysis can be more useful for short-term predictions, as day traders and swing traders usually rely on this method while trading. They may focus less on fundamental analysis. Contrarily, investors or long-term investors find fundamental analysis as a reliable tool to identify future business potential and assist decision-making. Fundamental analysis can prevent investors from making hasty decisions that may not turn out to be lucrative in the long run.
This method also helps in identifying the new and upcoming businesses or companies that may have the potential to grow in the long term and deliver excellent returns. Analysts can assess whether a stock is currently trading at its fair price or if it is higher or lower. Fundamental analysis help analysts to identify any potential risks in the foreseeable future. If they do professionally, they can identify these issues and also strategise viable solutions to evade them.
How To Conduct Fundamental analysis
Before doing fundamental analysis, it may be a good idea to read up some educational material or books related to this subject so that you can understand the process and approaches in-depth. Here are some steps you can follow to do a thorough fundamental analysis of a company or stock:
1. Get familiar with the company
If you are considering a certain company for long-term investment, first try to study it in as much detail as possible. Go through the website, learn about its product, market, how it has been performing, its future goals and past decisions. Once you know as much as possible about the business, you are going to be in a better position to evaluate the other variables.
2. Read the financial reports
After gaining a full understanding of the company, you may look into the financial reports, such as the balance sheets, profit-and-loss statements, operating costs, cash flow, revenue and expenses. Check whether the net profit has been on the rise in the past five years. If this is so, then it is a positive sign. You may also calculate the compounded annual growth rate (CAGR). You can find financial reports of a company in trading and investing platforms online.
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3. Check the debt
Debt can impact the growth potential and performance of a company negatively. It is advisable to refrain from investing in companies that have high debt, as this can affect the returns. The ideal debt-equity ratio is less than one. Look for a company with this debt-equity ratio for safer investments.
4. Study the competitors
Competition is an important factor in determining whether a company can scale and grow as effectively as it aims to. If the competitors have a better reputation in the market and produce better quality products, the chances of the company succeeding can be less. It is better to go with a company that has already established itself as a leader in the market and that enjoys a better reputation than its competitors.
5. Analyse the future prospects
Some products are seasonal and may even lose their significance with time. Others can be evergreen products or they may have a use for customers regularly in the foreseeable future. Analyse these aspects to see if the company has the potential to grow and sustain itself in the long run. Diminishing product values results in decreasing stock values.
6. Review all aspects periodically
Micro-and macroeconomic changes can affect the prices and valuation of companies. The occurrence of new events and the innovation of technology can make certain products obsolete or enhance their existing value. This makes it important to remain aware of the current happenings, read industry-relevant news and follow the company closely. This can help you plan to hold or sell your investments.
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