Fundamental Analysis Explained | US Investing Basics
In this video, we will introduce you to the basics of fundamental analysis.
First, it is important to understand what we mean by fundamental analysis.
Fundamental analysis is the method of assessing the intrinsic or true value of a security by analyzing various microeconomic, macroeconomic, and financial factors and also the company’s health, competition, and the market. Hence, the purpose of fundamental analysis is to determine the real value of a stock. Once the intrinsic value of a stock is determined, it is compared to the market value of the stock based on which investment decisions can be made.
There are two ways to conduct Fundamental Analysis: top-down, and bottom-up. As the name suggests, the top-down approach starts with a broader view of the economy, with a focus on the entire market, and finally zeroing down on the industry, sector, and then specifics of a particular company.
On the other hand, the bottom-up approach starts with analyzing the company, to begin with, and then broadens its scope to analyze the macroeconomic factors that impact the company’s performance and the stock price.
There are also two different approaches to fundamental analysis – the qualitative and the quantitative approach.
The qualitative approach analyzes those aspects of the business which are difficult to measure in terms of numbers like the business model, competition, quality of management, and corporate governance.
The quantitative approach, on the other hand, studies those aspects of a firm’s value that can be measured with the help of numbers like net profit, earnings per share, price to earnings ratio, dividend payout, the debt-equity ratio, and so on. Both these approaches are important because, in the initial days of a company, the numbers may not reflect truly if a company has the potential to realize profits going ahead.
Next, we will take a brief look into the fundamental analysis process.
First, one may start with an economic and market analysis. Here one needs to understand the structure of the industry and the market dynamics and analyze the competition. One also needs to understand the products or services and the problems they solve, the cost structure and how the company generates revenue. Finally, it is important to identify the growth objectives of the company and research the regulatory environment.
Next, one needs to analyze the financial statements. These would include the balance sheet, income statement, cash flow statement and so on to learn about key financial indicators.
Based on the above, one needs to identify value drivers or factors that increase the value of the business and make forecasts regarding those. One also needs to have an idea of factors that could affect such forecasts and tweak them over time as the economic conditions change. Once you have the forecasts, the next step would be to apply valuation models based on data from the above steps to arrive at an intrinsic valuation.
You would then combine your market analysis and company valuation to take a call on whether to buy, hold or sell a certain stock. As you can see, while a lot of fundamental analysis is quantitative, there are individual inputs that also go into the process such as determining the impact of competition or setting forecasts.
These individual inputs can be fine tuned both via experience in investing or experience in a particular industry.