6.2 What is fundamental analysis?

FUNDAMENTAL ANALYSIS

What do you do if you want to buy a house? You will look for it in terms of how big is it, when was it constructed, is it available for immediate possession, is there a mortgage on it, is it available at the right price and so on. You pick the stock of a company in the same way. Therefore, the first task is to asses the worth of the stock. The term fundamental analysis refers to the analysis of the economic well-being of a financial entity as opposed to technical analysis which is more interested only in analysing its price movements.

Fundamental analysis serves to answer questions such as:

  • Is the company’s revenue growing?
  • Is it actually making a profit?
  • Is it in a strong enough position to beat its competitors in the future?
  • Is it able to repay its debts?
  • Is the management trying to 'cook the book'?

Fundamental analysis is the examination of the underlying forces that affect the well-being of the economy, industry groups and companies. As with most analyses, the goal is to derive a forecast and profit from the future price movements. At the company level, fundamental analysis may involve examination of the financial data, management, business concept and competition. At the industry level, there might be an examination of the supply and demand forces for the products offered.

For the national economy, fundamental analysis might focus on economic data to assess the present and future growth of the economy. To forecast future stock prices, fundamental analysis combines economic, industry and company analyses to derive a stock’s current fair value and forecast its future value. If the fair value is not equal to the current stock price, fundamental analysts believe that the stock is either over or under-valued and the market price will ultimately gravitate towards a fair value. By believing that prices do not accurately reflect all the available information, fundamental analysts try to capitalise on perceived price discrepancies.

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