What is Fundamental Analysis?
In accounting and finance, fundamental analysis is a method of assessing the intrinsic value of a security by analyzing various macroeconomic and microeconomic factors. The ultimate goal of fundamental analysis is to quantify the intrinsic value of a security. The security’s intrinsic value can then be compared to its current market price to help with investment decisions.
Unlike technical analysis that concentrates on forecasting a security’s price movements, fundamental analysis aims to determine the “correct price” (true value) of a security. By knowing the right price, an investor can make an informed investment decision. A security can be overvalued, undervalued, or fairly valued.
Components of Fundamental Analysis
Fundamental analysis consists of three main parts:
- Economic analysis
- Industry analysis
- Company analysis
Fundamental analysis is an extremely comprehensive approach that requires a deep knowledge of accounting, finance, and economics. For instance, fundamental analysis requires the ability to read financial statements, an understanding of macroeconomic factors, and knowledge of valuation techniques. It primarily relies on public data, such as a company’s historical earnings and profit margins, to project future growth.
Top-down vs. Bottom-up Fundamental Analysis
Fundamental analysis can be either top-down or bottom-up. An investor who follows the top-down approach starts the analysis with the consideration of the health of the overall economy. By analyzing various macroeconomic factors such as interest rates, inflation, and GDP levels, an investor tries to determine the overall direction of the economy and identifies the industries and sectors of the economy offering the best investment opportunities.
Afterward, the investor assesses specific prospects and potential opportunities within the identified industries and sectors. Finally, they analyze and select individual stocks within the most promising industries.
Alternatively, there is the bottom-up approach. Instead of starting the analysis from the larger scale, the bottom-up approach immediately dives into the analysis of individual stocks. The rationale of investors who follow the bottom-up approach is that individual stocks may perform much better than the overall industry.
The bottom-up approach is primarily concentrated on various microeconomic factors such as a company’s earnings and financial metrics. Analysts who use such an approach develop a thorough assessment of each company to gain a better understanding of its operations.
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