Fundamental Analysis

Fundamental analysis is the examination of the underlying forces that affect the well-being of the economy, industry groups, and companies. As with most analysis, the goal is to derive a forecast and profit from future price movements.

Learning Tip

Fundamental Analysis is one of the two methods of study of investing. A good understanding of fundamental analysis will help you to find undervalued and strong businesses and stocks.

Understanding

Uses of Fundamental Analysis

At the company level, fundamental analysis may involve examination of financial data, management, business concept and competition. At the industry level, there might be an examination of supply and demand forces for the products offered. For the national economy, fundamental analysis might focus on economic data to assess the present and future growth of the economy.

To forecast future stock prices, fundamental analysis combines economic, industry, and company analysis to derive a stock’s current fair value and forecast future value. If fair value is not equal to the current stock price, fundamental analysts believe that the stock is either overvalued or undervalued and the market price will ultimately gravitate towards fair value.

Fundamentalists do not heed the advice of the random walkers and believe that markets are weak-form efficient. By believing that prices do not accurately reflect all available information, fundamental analysts look to capitalize on perceived price discrepancies.

Steps to Apply

How to Use Fundamental Analysis

Economic Forecast: First and foremost, in a top-down approach would be an overall evaluation of the general economy. The economy is like the tide and the various industry groups and individual companies are like boats. When the economy expands, most industry groups and companies benefit and grow. When the economy declines, most sectors and companies usually suffer. Many economists link economic expansion and contraction to the level of interest rates. Interest rates are seen as a leading indicator for the stock market as well. Once a scenario for the overall economy has been developed, an investor can break down the economy into its various industry groups.

Industry Group Selection: If the prognosis is for an expanding economy, then certain groups are likely to benefit more than others. An investor can narrow the field to those groups that are best suited to benefit from the current or future economic environment. If most companies are expected to benefit from an expansion, then risk in equities would be relatively low and an aggressive growth-oriented strategy might be advisable.

A growth strategy might involve the purchase of technology, biotech, semiconductor and cyclical stocks. If the economy is forecast to contract, an investor may opt for a more conservative strategy and seek out stable income-oriented companies. A defensive strategy might involve the purchase of consumer staples, utilities, and energy-related stocks.

Finding Stocks within Industry: Once the industry group is chosen, an investor would need to narrow the list of companies before proceeding to a more detailed analysis. Investors are usually interested in finding the leaders and the innovators within a group. The first task is to identify the current business and competitive environment within a group as well as the future trends.

How do the companies rank according to market share, product position, and competitive advantage? Who is the current leader and how will changes within the sector affect the current balance of power? What are the barriers to entry? Success depends on having an edge, be it marketing, technology, market share or innovation. A comparative analysis of the competition within a sector will help identify those companies with an edge, and those most likely to keep it.