science

Fundamental analysis

Fundamental analysis is a science topic covered in the lgStudy science library. This page brings together a partial reference excerpt, illustrations, worked examples, real-world applications and a short study plan, so you can understand Fundamental analysis rather than just read about it. In short: Fundamental analysis, in accounting and finance, is the analysis of a business's financial statements (usually to analyze the business's assets, liabilities, and earnings); health; competitors and markets. It also considers the overall state of the economy and factors including interest rates, production, earnings, employment, GDP, housing, manufacturing and management.

Key takeaways

Fundamental analysis belongs to science; place it in that map before memorising details.
Learn the definition first, then one example that makes the definition concrete.
Connect Fundamental analysis to a quantity you can measure, compute or draw — that is where exam questions come from.
Reproduce the core statement of Fundamental analysis from memory before moving on to harder problems.

Reference excerpt

Fundamental analysis, in accounting and finance, is the analysis of a business's financial statements (usually to analyze the business's assets, liabilities, and earnings); health; competitors and markets. It also considers the overall state of the economy and factors including interest rates, production, earnings, employment, GDP, housing, manufacturing and management. There are two basic approaches that can be used: bottom up analysis and top down analysis. These terms are used to distinguish such analysis from other types of investment analysis, such as technical analysis.

Fundamental analysis is performed on historical and present data, but with the goal of making financial forecasts. There are several possible objectives:

to conduct a company stock valuation and predict its probable price evolution; to make a projection on its business performance; to evaluate its management and make internal business decisions and/or to calculate its credit risk; to determine the intrinsic value of the share.

The two analytical models There are two basic methodologies investors rely upon when the objective of the analysis is to determine what stock to buy and at what price:

Fundamental analysis. Analysts maintain that markets may incorrectly price a security in the short run but the "correct" price will eventually be reached. Profits can be made by purchasing or selling the wrongly priced security and then waiting for the market to recognize its "mistake" and reprice the security. Technical analysis. Analysts look at trends and price levels and believe that trend changes confirm sentiment changes. Recognizable price chart patterns may be found due to investors' emotional responses to price movements. Technical analysts mainly evaluate historical trends and ranges to predict future price movement. Investors can use one or both of these complementary methods for stock picking. For example, many fundamental investors use technical indicators for deciding entry and exit points. Similarly, a large proportion of technical investors use fundamental indicators to limit their pool of possible stocks to "good" companies. The choice of stock analysis is determined by the investor's belief in the different paradigms for "how the stock market works". For explanations of these paradigms, see the discussions at efficient-market hypothesis, random walk hypothesis, capital asset pricing model, Fed model, market-based valuation, and behavioral finance. Fundamental analysis includes:

Economic analysis Industry analysis Company analysis The intrinsic value of the shares is determined based upon these three analyses. It is this value that is considered the true value of the share. If the intrinsic value is higher than the market price, buying the share is recommended. If it is equal to market price, it is recommended to hold the share; and if it is less than the market price, then one should sell the shares.

Use by different portfolio styles Investors may also use fundamental analysis within different portfolio management styles.

Buy and hold investors believe that latching on to good businesses allows the investor's asset to grow with the business. Fundamental analysis lets them find "good" companies, so they lower their risk and the probability of wipe-out. Value investors restrict their attention to under-valued companies, believing that "it's hard to fall out of a ditch". The values they follow come from fundamental analysis. Managers may use fundamental analysis to correctly value "good" and "bad" companies. Managers may also consider the economic cycle in determining whether conditions are "right" to buy fundamentally suitable companies. Contrarian investors hold that "in the short run, the market is a voting machine, not a weighing machine". Fundamental analysis allows an investor to make their own decision on value, while ignoring the opinions of the market. Managers may use fundamental analysis to determine future growth rates for buying high priced growth stocks. Managers may include fundamental factors along with technical factors in computer models (quantitative analysis).

Top-down and bottom-up approaches Investors using fundamental analysis can use either a top-down or bottom-up approach.

The top-down investor starts their analysis with global economics, including both international and national economic indicators. These may include GDP growth rates, inflation, interest rates, exchange rates, productivity, and energy prices. They subsequently narrow their search to regional/ industry analysis of total sales, price levels, the effects of competing products, foreign competition, and entry or exit from the industry. Only then do they refine their search to the best business in the area being studied. The bottom-up investor starts with specific businesses, regardless of their industry/region, and proceeds in reverse of the top-down approach.

Procedures The analysis of a business's health starts with a financial statement analysis that includes financial ratios. It looks at dividends paid, operating cash flow, new equity issues and capital financing. The earnings estimates and growth rate projections published widely by Thomson Reuters and others can be considered either "fundamental" (they are facts) or "technical" (they are investor sentiment) based on perception of their validity. Determined growth rates (of income and cash) and risk levels (to determine the discount rate) are used in various valuation models. The foremost is the discounted cash flow model, which calculates the present value of the future:

… excerpt ends here. Continue reading the full article.

Illustrations

Worked examples

Example 1 — a first encounter with Fundamental analysis

Start with the simplest possible case. Write down what Fundamental analysis claims or describes in one sentence, then invent the smallest concrete situation in which that sentence is true. In science, the smallest case is usually a single object, a single equation or a single measurement. Check that every symbol or term in your sentence has a meaning in that case.

Example 2 — changing one variable

Take the situation from Example 1 and change exactly one quantity: double it, halve it, or set it to zero. Predict what should happen to Fundamental analysis before you calculate. Comparing your prediction with the result is the fastest way to find out whether you understand the idea or only the words.

Example 3 — an exam-style question

Typical questions about Fundamental analysis ask you to (a) state it precisely, (b) apply it to given data, and (c) explain a limitation. Practise writing all three answers in under five minutes; the third part is what separates a full-mark answer from an average one.

Applications of Fundamental analysis

In research: Fundamental analysis appears in science research whenever the underlying quantities have to be modelled precisely. Papers usually cite it as a starting assumption and then explore where it breaks down.
In technology and industry: Engineering practice reuses Fundamental analysis in design rules, simulations and safety margins. Knowing the idea lets you read a specification sheet and understand why the numbers look the way they do.
In the classroom: Fundamental analysis is common in secondary-school and first-year university syllabi. It links to neighbouring topics Accounting terminology, Commodity markets, Corporate finance, so understanding it makes those chapters shorter.
In everyday life: Look for Fundamental analysis outside the textbook — in sport, cooking, traffic, electronics or the sky above you. An example you found yourself is remembered far longer than one you were given.

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How to study Fundamental analysis in 20 minutes

Read the reference excerpt below once, without taking notes.
Close the page and write down what Fundamental analysis means in your own words.
Compare your version with the excerpt and mark what you missed.
Work through the three examples above with pen and paper.
Explain Fundamental analysis out loud to somebody else — or to Teacher Smith in the lgStudy chat.

Frequently asked questions

What is Fundamental analysis in simple terms?

Why does Fundamental analysis matter?

Because it connects several science ideas at once: it gives you a definition you can apply, a quantity you can calculate, and a way to check whether a result is plausible.

How should I study Fundamental analysis?

Read the excerpt, restate it from memory, then work through the examples and applications listed on this page. The five-step study plan above takes about twenty minutes.

What does this page cover?

It gives you a compact reference excerpt plus original lgStudy explanations, examples, applications and study material on Fundamental analysis.