Fundamental analysis is a process of assessing the intrinsic value of a security, such as a currency or stock on an in-depth analysis of various financial, economic, qualitative, and quantitative factors. It involves the collection of information that is used to predict the future market trend and to conclude which securities are undervalued or overvalued.
Fundamental analysis is considered to be in contrast to technical analysis, which projects the direction of prices through scrutiny of past market data such as price and volume.
What to Know about Fundamental Analysis
Basically, the fundamental analysis assesses the underlying factors influencing the price of an item; it is often used to determine the share price of a firm but can be used to measure the price of everything, including bonds and currencies. As mentioned, the aim is to determine the intrinsic value of say, a stock to find out if the market is currently overpricing or underpricing it. The main objective is to buy at a discount before the market catches up.
There are various approaches used in the process. They include:
- Top-down analysis
- Bottom-up analysis
In this type of analysis, the investor starts by considering the status of the general economy. They will analyze the various macroeconomic factors such as inflation, interest rates, and GPD levels in a bid to determine the overall direction of the economy. The investor will be able to pinpoint economy sectors and industries that offer the best investment opportunities.
After that, the investor will assess the specific prospects and potential opportunities within the identified sectors. They will then analyze and select specific stocks within industries with the most potential.
This approach differs from the top-bottom analysis in that it dives into the analysis of the individual stocks rather than starting by analyzing from a larger scale. The rationale behind this approach is that there is a likelihood of individual stocks to perform much better than the collective industry.
The bottom-up approach is primarily focused on several microeconomic elements, such as the earnings and financial metrics of a company. A thorough assessment of each company is conducted to understand its operations better.
Both the bottom-up and top-down approaches aim to determine if the price fairly reflects the financial value of the company.
By assessing the strengths and weaknesses of the fundamentals, investors can evaluate the price as well as the level of risk associated with security.
Fundamental Analysis Tools
When a company reports a rise in their income, that will generally lead to a higher stock price and, in some cases, larger dividends. However, while the earnings are relevant, they do not tell you much by themselves. Earnings, on their own, cannot identify how the market values the stock. There is a need to use more fundamental analysis tools to start building a picture of how the stock is valued.
There are financial sites that will compete these ratios for you, but calculating it by yourself is not difficult. If you want to try it out, there are some fundamental analysis tools that you can use. These tools concentrate on earning, growth, and market value. Some of the factors to identify include:
Earnings per Share (EPS)
You cannot learn much about a company from its earnings of the number of shares. However, when you combine the two aspects, you get the most commonly used ratios for company analysis. Earnings per share indicate how much of a firm’s profits is assigned to each share of stock. The earnings per share is calculated as the net income divided by the number of outstanding shares.
Projected earnings growth (PEG)
Projected earnings growth anticipates the one-year earnings growth rate of the stock.
The price-to-earnings ration compares the current sales price of a company’s stock to its per-share earnings.
This ratio values a business’s stock price compared to its revenues. It is also referred to as the PDR, sales multiple, or revenue multiple.
The price-to-book ratio also referred to as the price-to-equity ratio, compares the stock’s book value to the market value. The ratio is arrived at by dividing the stock’s most recent closing price by last quarter’s book value per share. The book value is the value of an asset, as it appears on the firm’s records. It is equal to the cost of each asset minus the cumulative devaluation.
This is a ratio of yearly dividends compared to share price that is expressed as a percentage. To arrive at the ratio, you divide the dividend payments per share in a year by the share value.
Dividend payout ratio
The ratio compares dividends paid out to the stockholders to the company’s total net income. The ratio accounts for the retained earnings—revenue that is not paid out but rather kept for potential growth.
Return on equity
The return on equity is attained by dividing the company’s net income by shareholder’s equity. This is also referred to as the company’s return on net worth.
Criticism of Fundamental Analysis
There are two major categories of fundamental analysis criticisms: technical analysis, and efficient market hypothesis.
Technical analysis focuses on the price and volume movement of stocks. Technical analysts use charts and other tools to trade on momentum and ignore the fundamentals. One of the basic beliefs of the technical analysis is that there is a discount for everything offered in the market. All company news is already priced into the stock. Therefore, the stock’s price movements offer more intuition than the primary fundamentals of the company itself.
The Efficient Market Hypothesis
Those who follow this technique disagree with both fundamental and technical analysis. The hypothesis contends that it is impossible to beat the market through either the technical or fundamental analysis. Since the market powerfully prices all stocks on an ongoing basis, any chances for excess returns are almost immediately curved away by the market’ many participants. This makes it impossible for anyone to outdo the market over the long term implicitly.