What is fundamental analysis?
Fundamental analysis is a method of evaluating the intrinsic value of an asset and analysing the factors that could influence its price in the future. This form of analysis is based on external events and influences, as well as financial statements and industry trends.
Fundamental analysis is one of two major methods of market analysis, with the other being technical analysis. While technical traders will derive all the information they need to trade from charts, fundamental traders look at factors outside of the price movements of the asset itself.
Role of Fundamental Analysis in Investment Decisions
Fundamental analysis plays a vital role in investment decision-making, particularly for long-term investors seeking to build a portfolio of quality investments. By thoroughly analyzing a company’s financial health, industry position, and growth prospects, investors can make informed choices based on the underlying value of an asset. Fundamental analysis helps identify opportunities that may have been overlooked by the market or assess the risks associated with a particular investment.
It is important to note that fundamental analysis is just one of many approaches to investing, and it should be complemented by other strategies and considerations. Investors should also be aware of the limitations of fundamental analysis, such as the potential for subjective judgments, the impact of market sentiment, and unforeseen external factors that can influence investment performance.
Examples of fundamental analysis
There are various tools and techniques that can be used for fundamental analysis, but they have been categorised into two types of fundamental analysis: top-down analysis and bottom-up analysis. Top-down analysis takes a broader view of the economy, starting with the entire market before narrowing down into a sector, industry and finally a specific company. Conversely, bottom-up analysis starts with a specific stock and widens out to consider all the factors that impact its price.
Most fundamental analysis is used for evaluating share prices, but it can be used across a range of asset classes, such as bonds and forex.
The tools that traders might choose for their fundamental analysis vary depending which asset is being traded. For example, share traders might choose to look at the figures in a company’s earnings report: revenue, earning per share (EPS), projected growth or profit margins. While forex traders may choose to assess the figures released by central banks that allow insight into the state of a country’s economy.
Pros and cons of fundamental analysis
Pros of fundamental analysis
Fundamental analysis helps traders and investors to gather the right information to make rational decisions about what position to take. By basing these decisions on financial data, there is limited room for personal biases.
Rather than establishing entry and exit points, fundamental analysis seeks to understand the value of an asset, so that traders can take a much longer-term view of the market. Once the trader has determined a numerical value for the asset, they can compare it to the current market price to assess whether the asset is over or under-valued. The aim is to then profit from the market correction.
Cons of fundamental analysis
Fundamental analysis can be time consuming, it requires multiple areas of analysis which can make the process extremely complicated.
As fundamental analysis takes a much longer-term view of the market, the results of the findings are not suitable for quick decisions. Traders looking to create a methodology for entering and exiting trades in the short term might be better suited to technical analysis.
It is also important to consider the best and the worst-case scenario. While fundamental analysis provides a more well-rounded view of the market, it is possible for negative economic, political or legislative changes to surprise markets.
While fundamental analysis is a valuable tool, it should be used in conjunction with other investment strategies and factors to form a well-rounded approach to portfolio management.