Fundamental Analysis

Fundamental analysis involves examining the economic, financial and other qualitative and quantitative factors related to a security in order to determine its intrinsic value. While typically this method is used to evaluate the value of a company’s stock, its use can be extended for any kind of security, such as bonds or currency.

Fundamental analysis, which is also known as quantitative analysis, involves delving into a company’s financial statements (such as profit and loss account and balance sheet) in order to study various financial indicators (such as revenues, earnings, liabilities, expenses and assets). Such analysis is usually carried out by analysts, brokers and savvy investors.

Fundamental Analysis: Two Approaches

While carrying out fundamental analysis, investors can use either of the following approaches:

1. Top-down approach: In this approach, an analyst investigates both international and national economic indicators, such as GDP growth rates, energy prices, inflation and interest rates. The search for the best security then trickles down to the analysis of total sales, price levels and foreign competition in a sector in order to identify the best business in the sector.

2. Bottom-up approach: In this approach, an analyst starts the search with specific businesses, irrespective of their industry/region.

Fundamental Analysis: How Does It Work?

Fundamental analysis is carried out with the aim of predicting the future performance of a company. It is based on the theory that the market price of a security tends to move towards its “real value” or “intrinsic value.” Thus, the intrinsic value of a security being higher than the security’s market value represents a time to buy. If the value of the security is lower than its market price, investors should sell it.

The steps involved in fundamental analysis are:

1. Macroeconomic analysis, which involves considering currencies, commodities and indices.

2. Industry sector analysis, which involves the analysis of companies that are a part of the sector.

3. Situational analysis of a company.

4. Financial analysis of the company.

5. Valuation

The valuation of any security is done through the discounted cash flow (DCF) model, which takes into consideration:

1. Dividends received by investors

2. Earnings or cash flows of a company

3. Debt, which is calculated by using the debt to equity ratio and the current ratio (current assets/current liabilities)

Fundamental Analysis: Benefits

Fundamental analysis helps in:

1. Identifying the intrinsic value of a security.

2. Identifying long-term investment opportunities, since it involves real-time data.

Fundamental Analysis: Drawbacks

The drawbacks of fundamental analysis are:

* Too many economic indicators and extensive macroeconomic data can confuse novice investors.

* The same set of information on macroeconomic indicators can have varied effects on the same currencies at different times.

* It is beneficial only for long-term investments.