Fundamental analysis is a strategy used in determining the intrinsic value of securities such as stocks based on the relevant economic and financial factors. In fundamental analysis, both macroeconomics factors such as the state of the economy and microeconomic factors such as how the individual company is run are considered.
The end goal of doing this analysis is to help the investor determine whether the shares of a given company are undervalued or overvalued before making an investment decision. Unlike technical analysis that considers historical data regarding the performance of the company, fundamental analysis focuses on the present conditions, both on the macro and micro levels.
Components of fundamental analysis
Fundamental analysis is mainly comprised of three main components; economic analysis, industry analysis, and company analysis. Let’s discuss each of these in detail.
- Economic analysis: With economic analysis, the research is done on the entire economy of a given country. Some of the factors considered while doing economic analysis include inflation rates, changes in GDP, interest rates, and several macroeconomics factors.
- Industry analysis: With industry analysis, the research is done on a given industry in which the stocks of a company in question operates. For example, if you are analyzing stocks of a company like Ford, you will have to analyze how the entire automotive industry has been performing in the last couple of months or years.
- Company analysis: This analysis focuses on the microeconomic factors such as the performance of the company in the last couple of months or years. This requires reading company financial documents such as financial statements, balance sheets, and many more.
Approaches used in fundamental analysis
While doing fundamental analysis, there are mainly two approaches you can use; the top-down approach and the bottom-up approach. So, how are these two approaches implemented?
This approach is mainly used by long-term investors. With this approach, the investor will start by doing economic analysis. This focuses on macroeconomic factors, including GPD levels, interest rates, inflation, etc. The investors will proceed to analyze the industry in which the company operates. This involves analyzing the general performance of all the companies in that industry. He will then finalize by doing a company analysis.
- Bottom-up analysis
This approach is mainly used by short-term investors such as day traders. So, instead of starting with the macroeconomic factors, investors using this approach will begin by analyzing the individual stocks of the company in question. He will then proceed to examine the industry. Finally, he will look at the general economy and the macroeconomic factors that could affect the performance of stocks for the company in question.
Which of the two is the best approach?
The choice between these approaches should largely depend on your fundamental goal of investing in the stocks of a given company. If your goal is to buy and sell the stocks within a short period, then focusing on the company’s performance is the best approach. However, long-term investors use the top-down approach because it focuses on the bigger picture.