Fundamental analysis is a method used by traders that attempts to gauge the inherent value of a security by examining relevant economic and financial data. Fundamental analysis involves the study of factors that can affect the security's value. These factors include: overall economic trends and industry conditions, company-specific factors such as earnings and sales growth, as well as financial strength.
While technical analysis is primarily concerned with determining “when” to act by focusing on how supply and demand for shares will affect the price of a stock in the near-term, fundamental analysis essentially attempts to answer the question of “why” the stock price of a given company is behaving the way it is and focuses on a company’s value and whether the company will continue to grow its earnings in the future and by how much.
The underlying theory behind fundamental analysis is that if a company performs well in terms of growing its business, this fact will ultimately be reflected by a higher stock price.
Why traders use fundamental analysis
When buying anything, people like to believe that they are paying a fair price for the value they are receiving. Fundamental analysis offers traders the potential to determine - or at least to estimate - the relative value of a given company compared to its current stock price. Fundamental analysts can also compare the relative value of one company to that of another company or group of companies in order to refine their search to the best opportunities available.
What fundamental analysis allow you to do
Traders typically rely on fundamental analysis to do several things:
- Identify companies that possess superior growth and/or value characteristics.
- Help reduce emotional decision-making – Rather than relying on “gut feelings”, traders can look for potential buy/sell signals that are generated based on specific and objective criteria.
- Help identify and/or confirm buy and sell signals generated from other forms of analysis such as technical analysis. For example, if a trader gets a buy signal on a number of stocks using a technical tool, he or she may then apply certain fundamental analysis filters (such as historical or projected earnings growth, for example) to narrow the list down to the best candidates.
- A trader can also work in the opposite direction and use fundamental criteria to first identify a list of companies that possess superior growth or value characteristics, and then apply some technical analysis tools to that list of stocks to find buying opportunities.
One criticism of fundamental analysis is that while it may help an analyst to find a stock that is an exceptional bargain based on its current fundamentals, there is no guarantee that other investors will recognize this value and reward the company with a higher stock price. Therefore, fundamental analysts may need to be more patient in waiting for favorable opportunities to pan out.
The goal of fundamental analysis is not necessarily to find stocks that are about to make immediate price movements.
One approach to fundamental analysis is to use it to identify companies that are performing well as a business enterprise in the belief that their share price will perform well over time as a result. Another approach is to identify stocks whose value is presently not recognized by the majority of investors, but which the trader believes with a high degree of confidence will be recognized and rewarded over time.
Shorter-term traders tend toward technical analysis while longer-term investors often prefer to use fundamental analysis. Still, as we have pointed out, while these two approaches are based on different assumptions and inputs, fundamental and technical analysis techniques can certainly be used in a complementary fashion.
Other considerations regarding the use of fundamental analysis
Fundamental analysis has many disciples. Still, like any other type of market analysis, it offers no guarantees, but can be a helpful tool in quantifying stocks that meet specific objective criteria. While many traders make buy and sell decisions based on subjective opinions, assessing fundamental analysis tools can help a trader to develop a more objective method for identifying superior performing companies.
While some traders will initially focus much of their attention on using fundamental analysis to decide what to buy, it should also be noted that over time one of the greatest potential benefits associated with fundamental analysis is in helping traders to determine what not to invest in. If a company is performing poorly and/or if the price of the stock is overvalued relative to the company’s underlying worth, there might be added risk involved in buying the company’s stock.
The critical piece of any kind of analysis is to help make a complicated decision easier, even if things don’t turn out as hoped. Having a clear set of guidelines, however imperfect, is preferable to trading decisions based on emotion. Many traders get caught focusing on the waves and swells of the market, rather than the underlying tide. Fundamental analysis can serve as a compass, anchor, and rudder to help you better navigate your trading decisions and help you to determine what to buy and why to buy it.