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Fundamental Analysis

A method of assessing the intrinsic value of a security by analyzing various macroeconomic and microeconomic factors

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 that can be compared to its current price to influence investment decisions.

 

Fundamental Analysis

 

Unlike technical analysis that concentrates on forecasting a security’s price movements, fundamental analysis aims to determine the correct price 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:

  1. Economic analysis
  2. Industry analysis
  3. 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, revenues, and profit margins to project its 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 economies with the best investment opportunities.

Afterward, the investor assesses the prospects and potential opportunities within the identified industries and sectors. Finally, they analyze and select the individual stocks within the most promising industries.

 

Top-down Approach
Figure 1. Top-down approach

 

 

On the other hand, 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 the individual stocks may perform much better than the overall industry.

The bottom-up approach is primarily concentrated on various microeconomic factors such as the company’s earnings, revenues, P/E ratios. Analysts who use such an approach develop a thorough assessment of each company, including visiting the companies to gain a better understanding of their operations.

 

Bottom-up Approach
Figure 2. Bottom-up approach

 

Additional Resources

CFI is the official provider of the global Financial Modeling & Valuation Analyst (FMVA)™ certification program, designed to help anyone become a world-class financial analyst. To keep advancing your career, the additional resources below will be useful:

  • Comparable Company Analysis
  • Economic Indicators
  • Technical Analysis – A Beginner’s Guide
  • Valuation Methods

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