Fundamental Analysis is a criterion used in measuring the intrinsic value of a particular security by analyzing the related economic and financial parameters. It, therefore, entails studying all factors that can affect the value of a particular security.
The factors considered are either macroeconomic or microeconomic aspects. Examples of macroeconomic factors are the conditions of the particular sector or the state of the economy. Microeconomic factors can be aspects such as the effectiveness of the firm’s management strategy.
At the end of the day, all that is required is to arrive at a figure with which an investor can make a comparison with the current price of security thus gauge whether that security is undervalued or overvalued.
Concept of Fundamental Analysis
Fundamental analysis is considered to be different from technical analysis; technical analysis concentrates on the trend of the prices through the analysis of historical data of the market i.e. market volume and security price. Fundamental analysis, however, attempts to determine whether the said security is appropriately valued within the broader market sector.
The strategy employed in the fundamental analysis involves inspecting the security price from an external perspective and delve deeper into the internal parameters to identify the securities that are valued incorrectly by the market. In essence, the analysts first study the state of the economy concerning the market and then later analyze the strength of the particular sector and finally concentrate on the firm’s performance. This chronological strategy helps to arrive at a just valuation of the stock.
Resources used in Fundamental Analysis
The analysis uses public data in its evaluation of any security such as a stock or bond. In the case of a bond, the data used are economic factors like interest rates after which the overall state of the economy is evaluated and lastly the bond issuer information is studied i.e. any potential change in the credit rating of the issuer.
Concerning stock the data used is the revenues and earnings, return on equity of the shareholders, future growth, profit margin and any other relevant data that will help ascertain the underlying value of the firm and the potential for its future growth
Investing using fundamental Analysis
Suppose the intrinsic value of the security is higher than the current market price then the stock is determined to be undervalued; therefore a buy recommendation is advised on such a scenario. If the reverse is observed, the intrinsic value is lower than the current market price, then the stock is overvalued and therefore a sell recommendation is advised.
Using these information investors have to options in play; either to invest long or go short. The criteria of going long involve purchasing with the prediction that the stock price will rise; this strategy is done on companies that are deemed strong. The go short mechanism involves selling stock shares that are deemed to fall in price shortly and thus repurchase the shares at a lower price; this strategy is usually conducted on firms that are deemed weak.
Categories of Fundamental Analysis factors
The different factors used in fundamental analysis can be categorized into two major groups, quantitative and qualitative factors.
These are measurable characteristics of a business; they are capable of being expressed numerically as figures. The important source of quantitative data is the financial statements i.e. revenue, assets, profits and other documents which detail the financial portfolio of the company.
Use of financial statements can disclose information of the company about its financial prowess to make decisions on the investment to be made. The three critical financial statements to be considered are income statements, cash flow statements, and balance sheets. To learn more, you may visit Day Trading Academy provided by Marcello Arrambide.
1. The balance Sheet
This document is used to keep a record of the assets, liabilities, and equity of a firm at a particular period. It is named as so due to the balance it has on the company’s financial structure i.e. total assets equals the liabilities of the company with the equity of the shareholders.
Assets entail all the resources owned or controlled by a business at a given period. Examples of assets are machinery, buildings, inventory, and cash. Liabilities entail the debt, that ought to be paid, and equity represents the total sum that the business owners have contributed to the business. These two concepts represent the total value of financing that the company has used to acquire its assets.
2. The Income Statement
This document measures the firm’s performance at a specific period. It is usually reported quarterly or annual basis. It conveys information about the firm’s revenues, expenses, and profits that have been accrued due to the operations conducted for that period.
3. Statements of Cash flows
This document entails a record of the cash inflows and outflows of a firm at a given period. It focuses on the following:
- Cash from Investing (CFI)
Entails the cash used for asset investments and proceeds from the sale of other resources such as machinery or long-term assets.
- Cash from Financing (CFF)
Entails cash paid or received from the borrowing or issuance of funds.
- Operating Cash flow (OCF)
Entails cash generated daily.
Are less tangible factors that relate to the quality as opposed to the size of a firm. Examples can be the character of the key executives of the firm, brand recognition, patents or proprietary technology.
The key qualitative factors are:
- The Business Model
Entails the purpose of the business and what service will it provide to its consumers.
- Competitive Advantage
Involves the strategy used by the firm to get ahead of the competition and enjoy growth and profit.
Involves the manner and level of management in the firm and their role in the business’ goals.
- Corporate Governance
Entails the policies put in place within a firm giving the relationships and duties among management, directors, and stakeholders.
Among the key things to take note is that Fundamental analysis is that it is mostly applied in stocks; it is, however, a general criterion used to evaluate any security i.e. a bond or a derivative. Another point is that fundamental analysis entails analyzing the broad economy to the fine details of the firm.
This analysis is a way of determining the validity of stock in the market; they search for stocks that are trading at prices higher or lower than the real value, therefore, giving buy recommendation or sell recommendation as per the particular scenario analyzed.