Fundamental Analysis: Pros and Cons

In this article, we will see the strengths and weaknesses of the fundamental analysis. This will help you to know what fundamental analysis can do and what it can’t in a better way.

Learning Tip

Fundamental analysis is a greatly effective method for long term investing. It helps you to understand the true value of stock by understanding or valuing its business. But you should know everything about it. It means you must be aware of its strengths and weaknesses both.

Understanding

Strengths of Fundamental Analysis

Long-term Trends: 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 pick the right industry groups or companies.

Value Investing: Sound fundamental analysis will help identify companies that represent a good value. Some of the most legendary investors think long-term and value. Graham and Dodd, Warren Buffett and John Neff are seen as the champions of value investing. Fundamental analysis can help uncover companies with valuable assets, a strong balance sheet, stable earnings, and staying power.

Business Acumen & leading indication: One of the most obvious, but less tangible, rewards of fundamental analysis is the development of a thorough understanding of the business. After such painstaking research and analysis, an investor will be familiar with the key revenue and profit drivers behind a company. Earnings and earnings expectations can be potent drivers of equity prices. Even some technicians will agree to that.

Relative Valuation: Stocks move as a group. By understanding a company’s business, investors can better position themselves to categorize stocks within their relevant industry group. Knowing a company’s business and being able to place it in a group can make a huge difference in relative valuations. Now Let’s look into the weaknesses of fundamental analysis.

Understanding

Weaknesses of Fundamental Analysis

Time Constraints: Fundamental analysis may offer excellent insights, but it can be extraordinarily time-consuming. Time-consuming models often produce valuations that are contradictory to the current price prevailing on Wall Street.

Quite Specific: Valuation techniques vary depending on the industry group and specifics of each company. For this reason, a different technique and model is required for different industries and different companies. A subscription-based model may work great for an Internet Service Provider (ISP) but is not likely to be the best model to value an oil company.

Subjectivity: Fair value is based on assumptions. Any changes to growth or multiplier assumptions can greatly alter the ultimate valuation. Fundamental analysts are generally aware of this and use sensitivity analysis to present a base-case valuation, an average-case valuation, and a worst-case valuation. However, even on a worst-case valuation, most models are almost always bullish, the only question is how much so.

May based on lies: The majority of the information that goes into the analysis comes from the company itself. Companies employ investor relations managers specifically to handle the analyst community and release information. As Mark Twain said, “there are lies, damn lies, and statistics.” When it comes to massaging the data or spinning the announcement, CFOs and investor relations managers are professionals.