Fundamental analysis is a method of determining a stock's fair market value. Fundamental analysts examine a company's financial statements, health, competitors, and markets. Fundamental Analysis can be done on historical data, as well as present data, to make predictions. This analysis considers various factors, including the overall state of the economy and other factors that may impact a company's bottom line.
Fundamental analysis is a vital tool for investors. It can give them an insight into a company's true value and help them make informed decisions about whether or not to invest in a particular company. It is also important to remember that out of the different types of fundamental analysis, no single one is perfect. Usually, a combination of different methods is often required to get the most accurate picture possible, as each has its purpose.
Fundamental analysis is often contrasted with technical analysis, which looks at price trends and chart patterns to predict where a stock is headed.
How does it work?
The goal of fundamental analysis is to determine a company's intrinsic value. This is done by analyzing a company's financial statements and performing a valuation on the company. The intrinsic value is then compared to the stock's current price to see if it is undervalued or overvalued.
The three main types of financial statements in the fundamental analysis are the balance sheet, income statement, and cash flow statement. Each of these provides different information about a company's financial status.
Balance Sheet
The balance sheet shows a company's assets, liabilities, and shareholder equity. This information can calculate essential ratios such as the debt-to-equity ratio and the working capital ratio.
Income Statement
The income statement shows a company's revenue and expenses over some time. This information can calculate the profit margin and other important ratios.
Cashflow Statement
The cashflow statement shows a company's cash inflows and outflows over some time. This information determines the free cash flow and other important ratios.
The Two Fundamental Analysis Approaches
Regarding fundamental analysis, investors choose two options: top-down and bottom-up approaches.
Top-Down
The top-down fundamental analysis starts with the overall economy, including international and national economic indicators, and then drills down to specific industries and companies. It relies on economic indicators to predict which sectors or companies will do well. It is a more general approach and is less likely to be affected by individual company missteps.
Bottom-Up
The bottom-up fundamental analysis starts with individual companies and then builds up to the overall economy. It relies on studying a company's financial statements to predict its future success. This approach focuses on individual companies and can be more susceptible to stock market fluctuations. It is essentially the reverse of the top-down approach.
