What is Fundamental Analysis

Fundamental analysis is a way to figure out the intrinsic value of a security by analysing its financial and economic factors. It helps investors determine if a stock is priced right, too low, or too high, so they can decide whether to buy, keep, or sell it. 

What is fundamental analysis?

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 involves examining every aspect of a company’s operations through its balance sheet, past performance, financial reports, even market goodwill, management, and consumer behaviour 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.

What are the basics of fundamental analysis?

Fundamental analysis involves evaluating a stock by examining various factors to determine its intrinsic value and potential for long-term success. The basics of fundamental analysis include:

1. Company’s structure and revenue:

• Assess the organisation's overall structure and how it generates revenue.

2. Company’s profits over the years:

• Analyse the company's historical profit trends to understand its financial performance.

3. Revenue growth over the years:

• Evaluate the consistency and growth of the company's revenue over time.

4. Company’s debt:

• Examine the level of debt the company holds, as excessive debt can impact financial stability.

5. Corporate governance:

• Assess the company's governance practices and the effectiveness of its leadership.

6. Rate of turnover:

• Evaluate how efficiently the company manages its assets by considering the rate of turnover.

By considering these fundamental factors, investors can make informed decisions about the financial health and potential future performance of a stock.

Types of fundamental analysis

Fundamental analysis can be divided into two main categories:

Qualitative analysis: This type involves evaluating non-quantifiable aspects of a company, such as its management quality, brand reputation, and competitive positioning. Qualitative factors play a significant role in shaping an investor's perception of a company's future prospects.

Quantitative analysis: Quantitative analysis, on the other hand, focuses on tangible, measurable data. This includes financial statements, earnings reports, cash flow, and various financial ratios. Investors use these quantitative metrics to assess a company's financial health and performance.

Additional read: Difference Between Technical & Fundamental Analysis

Steps to do fundamental analysis

Fundamental analysis can be performed using two main approaches:

1. Top-Down Approach:

• Starting point: Macro level (Economic Environment)

• Process: The analysis initiates with an assessment of broader economic factors, such as overall economic conditions, industry trends, and market conditions.

• Focus areas:

  1. Economic conditions: Understanding the general economic health, interest rates, inflation, and other macroeconomic indicators.
     

  2. Industry trends: Identifying sectors with growth potential or those likely to outperform based on industry-specific factors.
     

  3. Market conditions: Analysing the overall market trends, sentiment, and risk factors.
     
     

• Narrowing focus: After evaluating these macro factors, the investor narrows down their focus to specific companies or assets that align with the identified economic and market trends.

2. Bottom-up approach:

• Starting point: Micro level (Individual Companies)

• Process: The analysis begins with a detailed examination of individual companies or assets, independent of broader economic considerations.

• Focus areas:

  1. Financial statements: Scrutinising financial statements to assess revenue, profit margins, debt levels, and other financial metrics.
     

  2. Competitive position: Evaluating the company's market share, competitive advantages, and overall position within the industry.
     

  3. Management quality: Assessing the effectiveness and reliability of the company's leadership and management team.
     
     

• Broader considerations: Once the specific companies are thoroughly analysed, investors may then consider broader economic and market conditions to ensure their chosen investments align with the overall economic landscape.

3. Key distinction:

• The top-down approach starts with the big picture (macro) and narrows down to individual assets, while the bottom-up approach begins with a detailed analysis of individual assets and may later consider broader economic factors.

4. Usage:

• The choice between these approaches often depends on investor preferences, the type of asset being analysed, and the prevailing market conditions. Some investors may use a combination of both approaches for a comprehensive understanding.

Fundamental analysis examples

Let us consider an example to illustrate how fundamental analysis can be done in the Indian stock market. Suppose we want to analyse the fundamentals of a company named ABC Ltd. The following steps can be taken:

1. Understanding the business: The first step is to do a qualitative analysis of the business. We have to check the products, promoters, and competitors of the company. We can study the mission, vision, and values of the company on their website.
   
2. Checking financial ratios: As there is a long list of companies in the stock exchange, we can easily use financial ratios to select healthy companies from the stock market. We can check the following ratios:
   
   
   • EPS (Earnings per share): Increasing EPS for the last 3-5 years is a good sign.
   • Price to earnings (PE) ratio: Lowest among the industry peers.
   • Return on equity: Average 3 years are less than 15% is preferred.
   • Debt to equity: Less than 0.5 is preferred.
   • Current ratio: Greater than 1 is preferred.
      
3. Past financial results: We can easily check the past financial results of a company by analysing its all three financial statements like balance sheet, profit & loss statement, and Cash flow statement. The thumb rule is that if revenues or sales, net profit, and margin are increasing for the last five years, then it might be a good stock to consider for long-term investment purposes.
   
4. Competitors analysis: The next step is to make a comparison of a company with its peers in the industry. We can check the USP (Unique selling proposition), competitive advantage, product costing, product pricing, brand value, and future strategies of competitors in the industry.
   
5. Debt of the company: The next step in how to do fundamental analysis of stocks is to check the total debt of the company, which means how much money a company owes to its creditors.

After analysing all these factors, we can arrive at an intrinsic value for ABC Ltd.’s stock and decide whether it is undervalued’s or overvalued.

Fundamental analysis provides a long-term perspective and helps investors make informed decisions based on a company’s intrinsic value rather than short-term market fluctuations. It provides a more accurate picture of a company’s value than technical analysis because it takes into account all factors affecting a company.

What is the difference between technical and fundamental analysis?

Technical analysis and fundamental analysis are two distinct approaches used in financial markets for making investment decisions. They differ in their methodologies, focus, and the types of data they rely on. Here are the key differences between these two forms of analysis:

1. Methodology:

• Technical analysis: Technical analysis is primarily concerned with studying historical price charts, patterns, and trading volumes. It assumes that past price movements and trading activity can provide insights into future price movements. It often employs charts and technical indicators like moving averages, RSI (Relative strength index), and MACD (Moving average convergence divergence) to identify potential trends and buy/sell signals.
• Fundamental analysis: Fundamental analysis, on the other hand, focuses on examining financial and non-financial data related to a company or asset. It involves assessing a company's financial statements, economic conditions, industry trends, and management quality to determine its intrinsic value. Fundamental analysts use this information to make investment decisions.

2. Data used:

• Technical analysis: Technical analysis primarily uses historical price data and trading volumes. It does not consider external factors like company performance or economic conditions.
• Fundamental analysis: Fundamental analysis relies on a wide range of data, including financial statements, earnings reports, economic indicators, industry reports, management assessments, and various financial ratios. This analysis considers both quantitative and qualitative factors.

3. Investment horizon:

• Technical analysis: Technical analysis is often associated with short to medium-term trading strategies. Traders using technical analysis may buy or sell assets based on technical signals that indicate potential price movements in the near future.
• Fundamental analysis: Fundamental analysis is more commonly associated with long-term investment strategies. Investors who use fundamental analysis are often interested in holding assets for an extended period. They seek to assess the long-term prospects and intrinsic value of an asset.

4. Focus:

• Technical analysis: The primary focus of technical analysis is on the timing of trades and entry/exit points. It aims to identify patterns and trends in price data to make profitable trading decisions.
• Fundamental analysis: Fundamental analysis concentrates on assessing the underlying value and financial health of a company or asset. It aims to determine whether an asset is overvalued or undervalued based on its intrinsic characteristics.

5. Market efficiency:

• Technical analysis: Technical analysts often assume that market prices already reflect all available information. They believe that historical price patterns can provide insights into future price movements.
• Fundamental analysis: Fundamental analysts believe that markets are not always perfectly efficient and that assets can be mispriced. They seek to identify these mispriced assets by evaluating fundamental data.

6. Tools and techniques:

• Technical analysis: Technical analysis uses tools like charts, trendlines, candlestick patterns, and technical indicators to make trading decisions. It often employs quantitative methods to assess price data.
• Fundamental analysis: Fundamental analysis employs financial ratios (for example, P/E ratio, debt-to-equity ratio), financial statements, economic analysis, competitive positioning, and qualitative assessments of management quality.

7. Use of news and events:

• Technical analysis: Technical analysis does not rely on external news or events. It assumes that all relevant information is already reflected in price data.
• Fundamental analysis: Fundamental analysis takes into account external news, earnings reports, economic developments, and other events that may influence the fundamental factors of an asset.

In summary, technical analysis focuses on price data and patterns, aiming to predict short-term price movements, while fundamental analysis delves into the intrinsic value of an asset, often with a long-term perspective. Both approaches have their merits, and investors may use them separately or in combination to make well-informed investment decisions.

What are the pros and cons of fundamental analysis?

Pros:

1. Long-term perspective: Fundamental analysis provides a long-term perspective, making it suitable for investors looking to hold assets for extended periods.
2. Informed decision-making: It allows investors to make well-informed decisions based on a company's financial health and economic conditions.
3. Value investing: Fundamental analysis is the foundation of value investing, a strategy that has yielded positive results for many prominent investors.

Cons:

1. Time-consuming: Performing fundamental analysis can be time-consuming and requires a significant amount of research and data analysis.
2. Influence of emotions: Investors may still be influenced by emotions and market sentiment, even when armed with fundamental analysis.
3. Complexity: Understanding financial statements and ratios may be challenging for inexperienced investors.

Conclusion

Fundamental analysis serves as a robust tool for investors seeking a thorough understanding of a company's intrinsic value and long-term potential. By evaluating financial and non-financial factors, investors can make informed decisions aligned with a stock's true worth.

While fundamental analysis provides a comprehensive view, it contrasts with technical analysis, which focuses on short-term price movements. Despite its time-consuming nature and susceptibility to emotional influences, fundamental analysis remains a cornerstone for investors adopting a strategic, value-oriented approach to the market.