Understanding Fundamental Analysis

Fundamental analysis is the cornerstone of investing. It involves the study of all relevant factors that affect an economy, market, or asset class in order to find its intrinsic or fair value.

Core Assumptions of Fundamental Analysis

  1. Price vs. Value: The price on the stock market does not fully reflect a stock's real value (intrinsic value).
  2. Long-Term Reflection: In the long run, the stock price will reflect the fundamentals.

Based on these assumptions, investment decisions are made:

  • If the intrinsic value is above the current market price, the asset is underpriced and should be bought.
  • If the intrinsic value is below the current market price, the asset is overpriced and should be sold.

Note: Key unknowns include the accuracy of the intrinsic value estimate and the time required for the market price to adjust.

Two Levels of Fundamental Analysis

1. Macroeconomic Analysis

Macroeconomic analysis examines factors that affect the economy in its entirety. It is primarily used in the evaluation of currencies, bonds, commodities, and stock indices.

Key Macro Factors Examined:

  • Interest rates
  • Inflation
  • Rate of growth
  • Employment/unemployment
  • Politics and national sentiment

This analysis determines if the economy is expanding or contracting, or if it is booming or in a slump.

The Economic Cycle

The economy follows a pattern of expansion and recession, which influences investment decisions. Where we are in the cycle decides on which asset class we should invest in (e.g., in a recession, stock markets often decline while bonds appreciate).

  1. Boom to Recession: Economic growth slows; investments in production decrease.
  2. Recession to Slump: Inflation drops; unemployment rapidly increases.
  3. Slump to Recovery: Interest rates decrease; housing activity and spending increase.
  4. Recovery to Boom: Growth increases; spending increases; inflation rises; employment reaches full capacity.

2. Microeconomic Analysis

Microeconomic analysis focuses on the economic well-being of a specific financial entity (a company). It is used primarily for the evaluation of individual stocks or corporate bonds.

Key Micro Factors Examined (Company Fundamentals):

Traders analyze a company's financial statements to determine if its stock is a good investment. This involves looking at:

  • Revenue growth
  • Profitability (making profits)
  • Liquidity and debt repayment ability
  • Market share and competition
  • Fair value of the stock in the long run

A stock's price is driven by the company's ability to grow sales and earnings, but it is also highly affected by the overarching economic conditions (macro factors).

Detailed Summary

Fundamental analysis is a core investing methodology used to determine the intrinsic or fair value of an asset, market, or economy by studying all relevant influencing factors. It operates on the core assumption that while market price may temporarily differ from intrinsic value, the price will reflect fundamentals in the long run. Investment decisions are based on buying underpriced assets (intrinsic value > market price) and selling overpriced assets (intrinsic value < market price). Fundamental analysis is performed at two levels: Macroeconomic analysis, which evaluates the entire economy using factors like inflation and interest rates, and Microeconomic analysis, which focuses on specific entities like companies by examining profitability, revenue growth, and debt structure.

Key Takeaways

  • Fundamental analysis aims to find the intrinsic or fair value of an asset.
  • A core assumption is that market price does not always reflect intrinsic value, but it will in the long term.
  • If intrinsic value is above market price, the asset is underpriced (buy).
  • If intrinsic value is below market price, the asset is overpriced (sell).
  • Investment decisions are subject to unknowns regarding the accuracy of intrinsic value estimates and the time needed for price adjustment.
  • Macroeconomic analysis examines factors affecting the entire economy (e.g., interest rates, inflation, employment) and is used for currencies, bonds, and indices.
  • Macro analysis helps determine where the economy stands in the economic cycle (Boom, Recession, Slump, Recovery).
  • Microeconomic analysis focuses on the financial well-being of a specific entity, typically a company, and is used for individual stocks and corporate bonds.
  • Key micro factors analyzed include revenue growth, profitability, liquidity, debt repayment ability, and market share.
  • A company's stock price is driven by its ability to grow sales and earnings, but is also influenced by overarching macro factors.