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How to apply Fundamental Analysis to your investment strategy

Investors can employ different approaches to scrutinize potential or present investment positions. There are two primary methodologies that are commonly discussed and compared to each other regarding stock trading, technical analysis and fundamental analysis. In this article we’ll be focusing on the latter, fundamental analysis.

What is fundamental analysis?

The definition of fundamental analysis outlines it as a methodology geared toward understanding and predicting a security’s intrinsic value based on a detailed examination of relevant financial, economic, quantitative and qualitative factors.

Fundamental analysts look into anything that can influence an asset’s value, from macroeconomic factors (such as industry trends and conditions) to microeconomic factors (like a company’s organizational structure). The ultimate objective of this approach is determining whether the price of a security (such as stock in a company) is currently over or undervalued.

In a nutshell, fundamental analysis looks at businesses at their basic or *fundamental* level, in order to determine their overall financial health. Some of the tools and metrics that investors following this approach use and study include a company’s balance sheet and strategic initiatives, wider consumer and market behavior, and revenue and asset management practices.

Fundamental analysis vs. Technical analysis

Technical analysis is usually described as the opposite of fundamental analysis, so let’s take a closer look at how they differ.

Fundamental analysts look into factors such as revenues, costs, capital, and liabilities (on a narrower company level), or inflation, demographics, socio-political matters, and labor and consumer trends (on a broader macro level). Technical analysis, on the other hand, forecasts the direction of prices through an analysis of historical market data such as price and volume.

Many traders would choose to specialize in either technical or fundamental analysis, while some (especially banks and brokerages) incorporate both methods to make more informed investment decisions.

Just remember that the better the quality of information that you have, the better the potential outcomes of your trades. For instance, you could apply technical analysis to pinpoint low-risk entry points for stocks or investments, and then use fundamental analysis to make the final decision to pull the trigger and buy into the market.

Approaches to fundamental analysis

fundamental analysis

There are two common approaches to fundamental analysis:

Top-down

This approach starts with an analysis of the economy as a whole, considering inflation, interest rates and GDP, to determine the economy’s general direction and identify specific industries or sectors of the economy that offer positive investment prospects.

Investors would then assess specific opportunities within these industries and sectors, in order to narrow down and eventually select individual stocks or assets with the greatest potential returns.

Bottom-up

By contrast, this method starts the analysis with individual stocks or securities, following the rationale that individual investments may actually perform much better than the overall economy.

The bottom-up approach to fundamental analysis concentrates on microeconomic factors, such as the financial metrics and earnings of a company, which is ultimately assumed to provide a better insight into a business’ operations and investment prospects.

Advantages of fundamental analysis

Fundamental analysts aim to understand an asset’s value and whether it is under or overvalued in the market, which entails adopting a longer-term perspective of the market.

Here are some advantages to this approach that allow smart investors to profit from corrections in the market:

  • Longer-term trends: Fundamental analysis can be ideal for long-term investments riding long-term market trends. Correctly predicting broader economic, technological, demographic or consumer trends may be difficult given the available data, but accuracy can reward patient traders who are able to select positive-growth companies or industries.
  • Business acumen: Conducting thorough research into a company provides fundamental analysts with a deep understanding of the key profit and value drivers behind a company and its industry. With these insights, investors are readily able to identify whether an opportunity or company is high- or low-risk, growth- or value-oriented, and cyclical or linear, in nature.
  • Value spotting: Fundamental analysis can help single out stocks representing good value by uncovering companies that hold valuable assets, reliable earnings, strong financials and high potential for growth.
  • Ease of categorization: Stocks move as a group, so understanding a company’s business can help traders better categorize stocks within relevant groups within the industry. Familiarity with a particular company and being able to place it in an industry group can be greatly beneficial in coming up with relative valuations.

Limitations of fundamental analysis

Barring any surprise economic, political or legislative changes within a market, fundamental analysis provides a well-rounded view of the market.

However, it is also advised to consider the best- and worst-case scenarios, as well as the limitations of the methodology:

  • Time constraints: While fundamental analysis takes a long-term view of a market and can provide excellent insights, it can also be quite time consuming. It entails a complicated process that demands multiple areas of analysis, and is therefore not ideal for making quick decisions.
  • Personal biases: Much of the information used in fundamental analysis is conveniently provided by companies, themselves. However, when reading these reports, take note that these may present sell-side biases that may inadvertently (we hope) inflate or deflate some of the data or findings presented.
  • Subjectivity: Fundamental analysts should be aware that determining an asset’s fair value is based on several assumptions. Final valuations of “fair value” may, therefore, drastically change when assumptions around growth or multipliers are altered in the process of evaluation.
  • Industry/company specificity: Different industries and companies may require different valuation techniques and models, which may constrain the amount or depth of analysis that can be performed, and further add to the time commitment required for fundamental analysis.

Conclusion

There isn’t any one combination of ratios or metrics that will instantly reveal whether a particular stock is a profitable investment. Whatever your level of experience, it is generally a good idea to base investment decisions on good data and structured analysis. Fundamental analysis, when used effectively, can be a solid way to identify strong companies or stocks.

Even without a specialized financial background, some patience and commitment can help you become an effective investment analyst. We’re confident that with a good understanding of fundamental analysis and some additional guidance from Academy, you can decide which tactics work best for you.

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