Fundamental analysis is used to determine a security’s value by focusing on the actual business of the company and its future prospects. This technique also includes evaluating specific industries or the economy as a whole. Put simply, the term refers to the analysis of a company’s economic well-being rather than only its price movements.
When performing fundamental analysis, questions such as these should be answered:
- Is the company’s revenue growing?
- Is it actually making a profit?
- Is it in a strong-enough position to beat out its competitors in the future?
- Is its products and/or services in demand now and will they be future?
- Is it able to repay its debts?
Of course trying to answer some of these questions can lead to many very involved questions, but that’s the whole point of technical analysis. It really boils down to one question: Is this stock a good investment? Think of fundamental analysis as a way to help answer this question.
There are two major divisions of fundamental analysis: quantitative and qualitative. While quantitative is capable of being measured or expressed in numerical terms (such as revenue, profit, or market cap), qualitative is related to or based on the quality or character of something (such as brand recognition or quality of management team). Neither qualitative nor quantitative analysis is better than the other. The wise investor will consider qualitative factors in conjunction with the hard, quantitative factors.
Before going further, it is important to define intrinsic value. One of the main reasons investors perform fundamental analysis is to figure out what price fully reflects a stock’s “real” value. Consider this, why would anyone go through the hassle of fundamental analysis if the stock market was always correct?
Let’s say a certain stock was trading at $5, but after extensive due diligence, you have decided the intrinsic value of the company is really worth $8 a share. Of course this is exactly what you want to find, a stock trading significantly below its intrinsic value. Once identifying such a stock, you rely on the assumption that in the long run, the stock will reflect its true value. Saying this, there is no way of telling how long you will have to wait. It may be weeks or possibly even years.
This is the whole idea of fundamental analysis. Finding discounted stocks by estimating the intrinsic value of various firms. If all goes well, you will eventually turn a profit as the market catches up to the fundamentals. The unknowns are if your estimate is correct and how long the wait is for the intrinsic value to be reflected in the marketplace.