This article explains the fundamental analysis in a practical way. After reading you will understand the basics of this powerful financial management tool.
What is fundamental analysis?
A fundamental analysis is usually used in the investments world and provides sound information about the financial statements and the financial health of a company or organization so that it becomes clear for a buyer whether it is attractive to buy a share or not.
Based on the stock exchange listing (Forex Futures), a fundamental analysis focuses on the interest rate, production, revenue and (asset) management of an organization.
This analysis has a look inside an organization and makes a forecast of the company’s results.
Fundamental analysis: different approaches
A fundamental analysis is executed based on current and historical financial information and backgrounds of a company. There are four different approaches:
- Calculation of the stock valuation of a company and a forecast of the probable price movements;
- Forecast and projection of the corporate performance;
- The evaluation of the (asset) management and making of internal corporate decisions;
- Calculation of the credit risk.
The counterpart of the fundamental theory is the technical analysis. Trends in the share price movements are reviewed in this analysis and the analyst will try to recognize patterns in these movements. Emotional responses of investors to price developments can lead to recognizable price graph patterns. Investors use both analyses, however, for the choosing/buying of shares (stock picking).
Division into three categories
The fundamental analysis itself comprises three sub-analyses:
- An economic analysis;
- An industrial analysis;
- A corporate analysis.
The intrinsic value of the shares is determined on the basis of these sub-analyses. If the intrinsic value is higher than the market price, it is advisable to sell the share.
If the price is equal to the market price of the share, it is advisable to keep the share and if this is below the market price, the best option is to sell the share.
Different portfolio styles
Investors can use the fundamental analysis within the different portfolio management styles.
Buy and keep
Investors believe in active steering between ‘good’ companies, as a result of which an investor will grow with the company. Even the shares of ‘bad’ companies fluctuate and create opportunities to make a profit.
They can also rely on the economic cycle before determining whether the circumstances are ‘good’ enough to buy shares from possibly suitable companies.
These investors distinguish themselves by a ‘short term ‘ approach, the market is a voting machine and not a weighing machine. Own decisions are made because of which signals from the market are ignored.
They restrict their attention to undervalued companies and they believe that these companies will not collapse quickly. The value is determined on the basis of a fundamental analysis.
Investors can choose for both a top-down and a bottom-up approach in a fundamental analysis:
- In the top-down approach the investor begins his analysis with the global economy, in which the Gross domestic product (GDP), growth rates, inflation, interest rates, exchange rates, productivity and energy prices play an important role. Next he targets a regional analysis of companies in which he pays attention to the total sales, price level, the effect of rival products and foreign competition. This is how he finds the best companies in a certain area.
- In the bottom-up approach the investor begins his search at specific companies, irrespective of their sector/area.
- Haugen, R. A., & Haugen, R. A. (2001). Modern investment theory (Vol. 5). Upper Saddle River, NJ: Prentice Hall.
- Pruitt, S. W., & Friedman, M. (1986). Determining the effectiveness of consumer boycotts: A stock price analysis of their impact on corporate targets. Journal of Consumer Policy, 9(4), 375-387.
- Roberts, H. V. (1959). Stock‐Market “Patterns” And Financial Analysis: Methodological Suggestions. The Journal of Finance, 14(1), 1-10.
- Thomsett, M. C. (1998). Mastering fundamental analysis. Kaplan Business.
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