Fundamental analysis can be an important tool in your trading operations, and is a major method of market analysis with a lot of utility in a number of global markets. But what is fundamental analysis, and how can you use it to make sound trading decisions? Read on to find out the basics.
What is fundamental analysis?
Fundamental analysis is a method of evaluating the intrinsic value of an asset, and analysing the factors that could influence its value in the future. This analysis is based on external events and influences, from macroeconomic factors such as industry conditions and the state of the economy, to microeconomic factors such as the effectiveness of the company’s management. The end goal is to arrive at a figure for the intrinsic value of an asset that an investor can compare with the asset’s current price. in order to see whether the security is undervalued or overvalued.
Fundamental analysis is one of two major methods traders use to analyse markets, with the other being technical analysis. In contrast to the former analysis method’s focus on outside factors that could affect an asset’s value, technical analysis is based on examining and predicting price movements in financial markets by using market statistics and historical price charts, observing patterns in the data and applying these patterns to inform trading decisions.
Why is fundamental analysis important?
Where technical analysis prioritises historical market data such as price and volume, fundamental analysis is more concerned with external factors and how they could influence prices, which allows for a more comprehensive view of any given asset. With this more comprehensive view, you can determine if an asset is underpriced or overpriced and make better informed trading decisions as a result, capitalising on changes in the market to secure undervalued assets with high intrinsic value.
Fundamental analysis also allows you to potentially anticipate and change trading operations in response to significant changes to the global socio-economic climate, which could help avoid any unexpected losses as a result of outside events changing the global markets.
Technical analysis has its utility in helping identify patterns and make informed predictions, and works well for short-term trading, but fundamental analysis allows you to determine the value of an asset over longer periods of time, and has more utility for trading operations that take place over these longer periods of time.
Types of fundamental analysis
There are a number of tools you can use in fundamental analysis, but the process itself can generally be sorted into two methods- top-down and bottom-up analysis.
Top-down analysis takes a broader view of the economy, starting with the entire market before narrowing down into sectors, industries and finally specific companies. On the other hand, bottom-up analysis starts with a specific stock and widens out, taking into consideration all the factors that could impact its price.
The type of financial instrument you want to trade in is also something important to consider when deciding on a mode of analysis. Fundamental analysis is useful for financial instruments that are more affected by external factors and traded over longer periods of time such as commodities and stocks, while technical analysis is more useful for financial instruments such as cryptocurrencies, that are generally traded over shorter periods of time.
The various factors that contribute to fundamental analysis can also be divided into two categories: quantitative and qualitative.
They relate to information that can be shown in numbers and amounts, and includes data such as revenue, assets and profit. Documents such as income statements, financial statements and balance sheets can be useful sources of quantitative data that can inform your analysis.
They relate to the nature and standard of the asset rather than its quantities in various regards, and includes brand-name recognition, patents, key executives and proprietary technology. Examining a company’s business models and managerial styles can be useful ways of gaining information on its qualitative properties, and it is also important to keep a close eye on the company’s industry to observe any changes in the inner workings.
Pros and cons
While fundamental analysis is important, it is not all-encompassing or applicable to any trading situation. With this in mind, here are some pros and cons to consider before you start using it to inform your trades.
- Fundamental analysis can help with determining the long-term value of an asset, which you can use to assess whether an asset is overpriced or underpriced at any given time
- Fundamental analysis takes external events into consideration, which gives you a more comprehensive view than looking at historical data could. Applying this knowledge could also help you avoid unanticipated financial consequences from significant social or economic upheavals affecting the value of a given asset
- Fundamental analysis takes a longer-term view of the market, so its results are not suitable for quick decisions or short-term trading
- Fundamental analysis can be time-consuming, as it requires exploring multiple socio-economic factors