Fundamental analysis of stocks has become more and more popular over the past couple of decades. Although technical analysis is the typical system one may think of when the stock market comes to mind – quick sells and steep risks – fundamental analysis is not a method to overlook.
Fundamental analysis works because it allows investors to make rounded decisions about their security, unveiling its intrinsic value by examining and comparing many factors before committing to an investment. This slow and steady stance prevents hasty decisions and lowers potential investment risks.
In this article, we will discuss the components of fundamental analysis, including qualitative and quantitative fundamentals, then briefly review technical analysis in comparison. To gain a better understanding of how fundamental analysis works and why it can be successful, read on.
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Table of Contents
What Is Fundamental Analysis?
Fundamental analysis is the process of analyzing the fair market value of a stock by examining factors such as economic stability and industry performance while also taking into account unquantifiable things such as the efficacy of a company’s management.
While it is most often used on stocks, you can apply fundamental analysis to many investment options. Any time you research a company and its executives with the potential of investing in them, you are engaging in fundamental analysis.
Analysts who deploy a fundamental frame of view can approach their findings in a top-to-bottom or bottom-to-top method. Both methods can yield positive results despite their difference in the process.
The Top-to-Bottom Approach in Fundamental Analysis
In the top-to-bottom method, an analyst will first determine the economy’s overall health by looking at things like interest rates, inflation, and Gross Domestic Product. These observations will help determine which industries and sectors hold the most promise. After deciding which industry or sector to go with, an analyst will then look for successful stock within the respective area.
The Bottom-to-Top Approach in Fundamental Analysis
The bottom-to-top method of fundamental analysis involves looking at individual stocks first and the overall health of the economy last. The bottom-to-top process requires the analyst to thoroughly research a company before comparing it to the surrounding market. A superior understanding of a company is arguably the most critical part of this method.
Types and Components of Fundamental Analysis
When we look at fundamental analysis, we can see two distinctive types to differentiate from. We have qualitative fundamentals, which focus on the elements of a company that can’t be measured, from how well consumers recognize their brand to how well they interact with their shareholders.
Then there are quantitative fundamentals that consider all the measurable aspects of a company, like what investments their money gets spent on or how much profit they made in a given time frame. You will need to think about all of these things to determine whether the stock or security you are interested in is worth the investment after all.
Qualitative Fundamentals Influence the Market
Qualitative fundamentals are the less obvious parts of fundamental analysis as they can’t be readily charted and tracked. If we are honest, this aspect relies primarily on opinion rather than inherent facts.
- Brand name recognition. Giant brand names have an economic moat around them, a term coined by Warren Buffet, which allows that company to have a guaranteed edge against their competitors. For example, Microsoft’s Personal Computer or Kellog’s PopTarts are both brands that are so commonly known that we use them to describe products like them.
- Quality of executives. Just like a football team is said to only be as good as its coach, the same can be said of a company and its leaders. Assessing a company’s leaders’ efficacy provides analysts with insight into how that company is run and how profitable it could ultimately be.
- Media coverage. Press has a way of influencing market trends of specific industries and individual companies alike. Analysts may see fit to take note of which influential entities are involved in the company or industry they are observing – we all saw what happened with Elon Musk and his tweets concerning GameStop and Bitcoin.
- Types of patents owned. A patent is a legal reservation for a company to use a product, idea, or system for a designated amount of time before releasing the public plans. This includes rights to the design and production process of the good in question.
- Business model. Examining what the business does and how well they do it will determine if they have a good business model or not. Are they making a profit while conducting their business?
- Competitive advantage. By having access to specific or valuable resources or having access to them at a lower price than a competitor, a company may gain an advantage in their market or industry, making their stocks potentially more valuable.
- Corporate governance. Corporate governance involves a company’s policies and actions regarding its public shareholders. You don’t want to do business with a shady organization, so check to make sure the company in question communicates well and fairly with its shareholders.
- Company industry. Individual companies are typically placed within a specific industry based on their most significant revenue source. Groups of companies will fall into an industry, and groups of industries fall into sectors. The success of an industry can play into a security’s true worth.
Quantitative Fundamentals Show Measurable Factors
Listed below are some common examples of tools that analysts use to conduct fundamental analysis on a company:
- Income statements. Income statements are reports over an extended period, commonly distributed as quarterly reports, which show a company’s revenues and expenses in the specified time frame.
- Balance sheets. So named because its components balance themselves out (Assets=Liability+Equity), balance sheets record a company’s shareholder equity, liabilities, and assets at a given point in time, like a snapshot.
- Cash flow statements. Cash flow statements determine the flow of cash into and out of the business through the day-to-day operations of the business, investments made by the company, or through interest on loans the company has issued. Cash flow statements are intricate, thus difficult to manipulate, making them trustworthy reports from which to glean information.
How Does Technical Analysis Compare To Fundamental Analysis?
Some people swear by the effectiveness of technical analysis over fundamental analysis. George Soros, for example, has built his fortune off of the cold hard math that drives technical analysis. Following the price differentials of stocks, technical analysts examine past patterns and use them to calculate future trends.
The Support and Resistance of Stocks Matter
The floor of a stock, or the lowest point it is projected to go before it turns around and becomes profitable again, is called a stock’s support. Once it has reached this point, it is a signal to analysts to buy the stock.
Alternatively, the ceiling, or highest point a stock is supposed to reach before it goes into a loss pattern, is called its resistance. A stock that has reached a resistance point is a signal to sell. The way to determine either support or resistance involves taking a 30-day report and drawing a point along all of the low points and high points, respectively.
Stocks Have Moving Averages
Moving averages are a way for analysts to maintain a relevant average despite fluctuations in prices over time. To determine a moving average, you take the closing prices of each day over the period being examined divided by the number of days in the term.
Stock Crossovers Can Help Make Predictions
When long-term and short-term averages meet, this is referred to as a crossover. If your short-term moving average crosses the long-term going upward, the stock is predicted to rise. Conversely, if the long-term average is crossed by the short going downward, the stock is about to fall.
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Conclusion
Fundamental analysis is a thorough, time-consuming process with low associated risk. It promotes slow but truly informed decisions about investments, which makes it more desirable for new traders that don’t want to take a significant risk. Even Warren Buffet has created a legacy with his successful adherence to the fundamentals.
Alternatively, technical analysis is a high-risk kind approach that is best left to those who are experienced in market trends. High risk does carry with it the chance of a high return, making technical analysis a means to make money quickly from stocks – or lose it all in one go.
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