When considering an investment, have you ever checked out a company's products, financial statements, its management team or the markets where it operates? Welcome to fundamental analysis!
With fundamental analysis, investors gather as much information as they can to better understand a company and help determine the intrinsic – or true – value of its stock. It's a useful approach when trying to figure outwhich company (or companies) to invest in.
Fundamental analysis focuses on getting to know a company and understanding some of the factors that may affect its stock price. It can give you a better understanding of a company's true value, which can help you determine if it's the right investment choice for your portfolio.
Many investment professionals consider fundamental analysis to be the most important step in the investment process. By examining a company's financial health, future growth prospects, the strength of its brand name and the quality of the management team, you'll be in a better position to determine if the stock is underpriced, fairly priced or overpriced.
With fundamental analysis, you can use a company's financial information to estimate future share price targets. That's because this type of analysis relies on two basic assumptions:
- Companies provide accurate and complete financial statements.
- In the long run, the price of a security will revert to its fair price.
Why Use Fundamental Analysis?
Investors who perform fundamental analysis believe that thoroughly understanding a company and creating an estimate of its value can lead to "buy low, sell higher" opportunities.
Warren Buffett, well-known for his value-style investing success using fundamental analysis, has said: "Price is what you pay, value is what you get." The idea is to pay a low price for something you believe has high value, in hopes the price will later rise.
You can think about what a stock is worth in a number of ways. For example:
- Consider the estimated future earning potential of the company
- Evaluate how much the company would cost if another company were to try to buy it.
- Compare key quantitative measures amongst similar companies (referred to as industry peers) to get a sense of the company's worth.
Longer-term investors tend to prefer fundamental analysis because it emphasizes the strength and long-term potential of a company. Value investors, like Warren Buffett, base their buy and sell decisions on the intrinsic value estimates they create using fundamental analysis.
A Closer Look at Fundamentals
To estimate a company's intrinsic value, fundamental analysis takes into account a large amount of data related to the company, its competitors, the industry and the broader economy. Here are some examples.
- Economy: Local, national and global economic data, issues and trends, which could impact a company's growth potential (e.g., interest rates, employment data, inflation, oil prices, etc.)
- Industry: Broader trends (e.g., technology, demographics, economy, energy, etc.), which could impact an industry as a whole and how the company is positioned.
- Competitors: The company's position in its industry and any sustainable advantage it has over competitors.
- Management team: The strength of the current management team and its history of success using capital to grow the company.
- Financial statements: A deep dive into revenue, earnings, profit margins, cash flow, return on equity and more.
Fundamental analysis can use a top-down or bottom-up approach. A top-down approach starts at the macro level (top of the list above) and works its way down to the company level. Alternatively, a bottom-up approach starts at the micro level (the bottom of the list) and works its way up to the global factors.
For more on fundamental analysis, check out Fundamental Analysis: Is It the Right Tool For You?
Fundamental analysis differs entirely from technical analysis, which is based only on the stock's historical price and trading information, which is then used to find patterns and price trends.
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