What is fundamental analysis?
Fundamental analysis is a method of evaluating a security to assess its intrinsic value by examining related economic, financial, and other qualitative and quantitative factors. Essentially, analysts examine everything that can influence a security’s value, including macroeconomic factors (e.g., economic and industrial conditions) and microeconomic factors (e.g., financial conditions and corporate governance).
What is the purpose of fundamental analysis?
As with most analyses, the goal is to obtain forecasts and profits from future price movements. At the company level, fundamental analysis can include examining financial data, management, business concepts, and competitors. At the industry level, it can examine supply and demand forces for the products offered. In the case of a national economy, fundamental analysis can focus on economic data to assess current and future economic growth.
Essentially, the ultimate goal of fundamental analysis is to produce a quantitative value that an investor can compare to the current price of a security, thereby indicating whether the security is undervalued or overvalued.
What are the benefits of conducting fundamental analysis?
Fundamental analysis is good for long-term investments based on very long-term trends. The ability to identify and predict long-term economic, demographic, technological, or consumer trends can benefit patient investors who choose the right industry groups or companies.
Sound fundamental analysis will help you identify companies that are highly valuable. Fundamental analysis can help you discover companies with valuable assets, a strong balance sheet, stable earnings, and sustained strength.
One of the most obvious, yet less tangible, benefits of fundamental analysis is developing a deep understanding of the business. After painstaking research and analysis, an investor will become familiar with the key revenue and profit drivers of a company. Earnings expectations can be a powerful driver of stock prices. A good understanding can help investors avoid companies prone to underperformance and identify those that continue to deliver. In addition to understanding the business, fundamental analysis allows investors to understand the key drivers and companies operating within an industry.
What are the weaknesses of fundamental analysis?
Fundamental analysis can offer excellent insights, but it can be extremely time-consuming. It’s also important to remember that fundamental analysis techniques vary across industries and the specifics of each company. Therefore, different techniques and models are required for different industries and companies. This can be time-consuming, which can limit the amount of research you can perform.
Another weakness of fundamental analysis is its subjectivity. This is because fair value is based on assumptions. Any changes in the growth or multiple assumptions can significantly alter the final valuation. Fundamental analysts are aware of this and use sensitivity analysis to provide a base valuation, a mean valuation, and a worst-case valuation. However, even with a worst-case scenario, most models are almost always bullish; the only question is by how much.
Another important issue is that most of the information used in analysis comes from the company itself. Companies employ investor relations managers, which can result in “artificially” maintaining positive investor sentiment despite the company’s situation being worse than it appears.
How reliable is fundamental analysis?
Fundamental analysis can be valuable, but its results should be approached with caution. If you’re reading research written by a sell-side analyst, it’s important to know the analyst responsible for the report. We all have personal biases, and every analyst does, too. There’s nothing wrong with that, and the research can still be valuable. Learn what the analyst conducting fundamental analysis means and learn about their success stories. Corporate statements and press releases offer excellent information, but they should be read with a healthy dose of skepticism, and be able to separate facts from exaggerations. Remember that press releases aren’t random; they’re an important PR tool for companies.
