Understanding a stock or bond's true value is essential for knowing when to buy and sell. Fundamental analysis is one of the most popular ways to determine this. Read more to learn what fundamental analysis is and how it can help you make better decisions about investing.
What Is Fundamental Analysis?
Fundamental analysis is the main method used to evaluate the quality of an investment. In many ways, it is considered the foundation of making informed investments. Fundamental analysis involves studying the qualitative and quantitative factors that affect the value of a stock, bond, or other kinds of security. The goal of this process is to identify the true value of a security. Investors can use this number as a benchmark to determine whether a security is currently priced under its value, over its value, or at price.
This evaluation comes from a variety of sources, including factors as large as the state of the economy and as small as how the company is managed. Typically, the current state of the economy is evaluated first, followed by the state of the industry that security is in. After analyzing these macroeconomic factors, the company's individual performance is evaluated, including their latest earnings reports and the company's management style. These factors culminate to determine the fair market value of the security.
How to Use Fundamental Analysis in Investing
Investors use fundamental analysis to maximize the performance of their portfolios. Generally, fundamental analysis is performed by stock analysts in order to give recommendations to an investor. Identifying securities that are are not accurately priced allows the investor to purchase stocks that are undervalued, avoid purchasing stocks that are overvalued, and sell overvalued stocks that the investor currently holds. Long-term investors tend to benefit the most from fundamental analysis, but short-term investors can also make use of this method to optimize their portfolio returns.
Analysts perform fundamental analysis whenever they are making recommendations to an investor, but markets see the greatest volume of trading after companies release their earnings reports. While companies can publicly release these reports at any time, most companies do so one to two weeks after each quarter ends.
Example of Fundamental Analysis
In order to understand how fundamental analysis works, it's best to provide an example. A stock analyst who concentrates on the biomedical industry may want to evaluate the stock price of a medical device company.
First, the analyst would consider the current state of the market. Has any recent political or economic news had an impact on the market? Next, the analyst would analyze the state of the biomedical industry. Has any legislation passed recently that could have an effect on the industry? How are similar companies in this sector performing? Is there promise for the industry? These macroeconomic factors play a huge role in forecasting the direction a stock price will go.
After studying macroeconomic factors, the analyst would move on to evaluating microeconomic factors. Utilizing the company's earnings statements, the analyst would pinpoint various elements that might influence the price of the stock -- including the company's overall sales, net income, and more.
Based on these factors, the analyst would then determine the stock's true value. This number would be used to compare against the stock's current price. Based on this, the analyst would make a recommendation to the investor about whether to purchase or sell the biomedical company's stock.
Fundamental Analysis vs. Technical Analysis
Fundamental analysis and technical analysis both play an essential role in determining the true value of a security, but they use different approaches. Fundamental analysis utilizes the current state of the economy and the company's individual financial performance to identify a security's value. Technical analysis focuses more heavily on the stock itself, analyzing the stock's past performance to identify trends and potentially find indications of how the stock will behave in the future.
While the two approaches are often viewed as opposing one another, the two methods can be successfully used in tandem. After performing fundamental analysis, an investor could examine the stock's chart to get a deeper insight into how the stock has behaved in relation to the market in the past. When utilizing this method, it is best practice to utilize monthly and weekly charts to find patterns that could provide insight into the stock's future behavior.
While proponents of fundamental analysis and technical analysis may argue that the two methods are diametrically opposed, they can in fact be combined into a more sophisticated analysis process that can provide great insight into the true value of a security.