Previously we took a deep dive into Technical Analysis, to understand it’s functionality and use cases broadly. Here let’s take a look into the Fundamental Analysis, a simple enough definition, its use cases, and a few extras.
Fundamental analysis is basically the examination of the underlying forces that affect the well being of the economy, industry groups, and companies. As of with most of the analysis, the goal here is to develop the forecast of price movements of the future in order to profit from it.
Remember, Fundamental Analysis allows investors to see whether the historical performance of the company i.e. Historical Data have already been priced into its own share price. Let’s take a simple example, according to the fundamental analysis if the share price is 100 USD although the current price is 50 USD means past performance of the company has not been justified by the company’s current share price. This creates an opportunity for an investor to buy something which has more value than what’s currently reflected in the market and make a profit once it reaches its fair value.
At a company level, analysts would use fundamental analysis to examine financial data, management, business concept or competition. At the industry level, there might be an examination of supply and demand forces of the products. When it comes to the national economy, the fundamental analysis might focus on economic data in order to assess the present and future growth of the economy.
Getting Technical with Stock Trade
Let’s talk about stocks, fundamental analysis is a technique that attempts to determine a security’s value by focusing on underlying factors that affect a company’s actual business and its future prospects. On a broader scope, you can perform fundamental analysis on industries or the economy as a whole. The term simply refers to the analysis of the economic well-being of a financial entity as opposed to only its price movements.
The fundamental analysis serves to answer questions, such as:
• Is the company’s revenue growing?
• Is it actually making a profit?
• Is it in a strong enough position to beat out its competitors in the future?
• Is it able to repay its debts?
• Is management trying to “cook the books”?
Of course, these are very involved questions, and there are literally hundreds of others you might have about a company. It all really boils down to one question: Is the company’s stock a good investment? Think of fundamental analysis as a toolbox to help you answer this question.
Oh, btw remember, the term fundamental analysis is used most often in the context of stocks, but you can perform fundamental analysis on any security, from a bond to a derivative. As long as you look at the economic fundamentals, you are doing fundamental analysis.
Fundamental analysis can help you ascertain whether a share price fall is a good buying opportunity or a pointer to sell, as it can signpost the warning signs that a company is about to become financially distressed.
First, investors should always keep an eye on cash flow statements, which show the actual cash movements during a year, to ensure that companies generate cash more often than they don’t, especially from their operations. Earnings growth that isn’t supported by cash flow generation over time will not be sustainable.
The second factor to watch is debt levels. Excessive – and growing – debt may highlight a company that’s heading for trouble. But the process of fundamental analysis can be involved and requires commitment, perseverance, and attention to detail.
As Investopedia.com notes, it can be a lot of hard work. “But that is, arguably, the source of its appeal. By taking the trouble to dig into a company’s financial statements and assess its prospects, investors can learn enough to know when the share price is wrong. “Those investors able to spot the market’s mistakes can make themselves money – a lot of it. At the same time, buying companies based on intrinsic long-term value protects investors from the dangers of day-to-day market flux.”
However, it’s often forgotten that the “intrinsic value” calculation also requires you to forecast future fundamentals, such as earnings per share and dividends per share. Individuals can either use analyst consensus forecasts – available from I-Net on Standard’s Online Share Trading website – or build their own models.
Fundamental analysis can be valuable, but it should be approached with caution. If you are reading research written by a sell-side analyst, it is important to be familiar with the analyst behind the report. We all have personal biases, and every analyst has some sort of bias. There is nothing wrong with this, and the research can still be of great value. Learn what the ratings mean and the track record of an analyst before jumping off the deep end. Such scenarios could be avoided by using advanced analytical tools that are available in the market at present. With a tool like Zepto, an analytical tool powered by AI and ML that users are able to identify insights and anomalies within their piles of data in just seconds. Moreover, it helps them to make the right calls at the right times ignoring the emotional or any other bias throughout the process.
Finally, it’s important to remember that the share price may not immediately shoot up or collapse after you’ve bought or sold a share based on your fundamental analysis. There could either be an incorrect assumption in your forecast or the market may be pricing some event of which you’re unaware into the share price. Alternatively, it may just take time for the market to recognize your genius and price the share as you believe it should be.