Fundamental analysis is an approach to analysing global financial markets that draws on the examination of the innate or intrinsic value of an asset or security and any factors that could impact that value, both now and in the future.
These fundamental factors could be bigger picture factors, which would include macroeconomic elements, for example the level of interest rates or the unemployment rate. Or they could be geopolitical elements, like a trade war, an election or an act of nature (an earthquake maybe). Then there are microeconomic, fundamental factors that can impact some securities and financial markets products, such as management decisions at the corporate level or industry specific legal changes.
In this article we are going to look at the basics of fundamental analysis, why it is important and how it works. We will also compare fundamental analysis to technical analysis, plus look at the advantages and limitations of the fundamental analysis approach, looking at examples.
Fundamental analysis basics
The basics of fundamental analysis are:
- Fundamental analysis is a process of calculating the real, true or “fair market” value of a financial market instrument or asset.
- Fundamental analysts attempt to identify financial markets or securities that are mis-valued according to the fundamental analysis approach, that are trading above or below their “fair market” value.
- Once the “fair market” value of a market or instrument is calculated from a fundamental analysis approach, then a trading or investing strategy can be decided upon. Depending on whether the current market price is above or below the projected “fair market” value, plus the degree to which it is above or below, then a trading or investing decision can be made.
Fundamental vs technical analysis
Often, fundamental and technical analysis are seen as competing approaches to analysing global financial markets. They are viewed as being at the opposite ends of a spectrum when analysing markets. However, they can be seen as complementary as well.
Here we will look at the similarities and differences in the approaches to fundamental and technical analysis.
Similarities
- Fundamental and technical analysts have the common goal of trying to identify when markets are likely to move either higher or lower in price.
- Both fundamental and technical analysis approaches also then look to make trading or investing decisions based on this analysis.
- Fundamental and technical analysts also both look to set targets, price levels at which they calculate and believe markets should be trading.
- In addition, both approaches will look to optimise the timings of entering or exiting trades or investments.
- To a lesser extent, both approaches also look to optimise the price level at which trades or investments should be entered or exited (although this is less true of fundamental analysis than technical analysis).
Differences
- Fundamental and technical analysts differ significantly in their basic approach to markets, in that a fundamental analyst looks to understand the “cause” of how a financial market is priced, where a technical analyst looks at “effect” of price and price movements.
- As fundamental analysis attempts to calculate the true, intrinsic value of an asset, the fundamental analyst needs to know the “why” of market movements. Technical analysts do NOT require the “why” of market movements, they simply look at the impact any event has on the price.
- Typically, but not solely, fundamental analysis looks at longer-term time horizons, so is more suited to longer-term trading or investing.
- Technical analysis is often viewed as more suited to shorter-term time frames than fundamental analysis, but technical analysis can certainly be applied to longer time frames and for longer-term trades or investments.
- The tools used by fundamental and technical analysts differ significantly too. The fundamental analyst looks at individual stock balances sheets, price to earnings ratios and other company data, alongside sector performance, bigger macroeconomic data, geopolitical influences. Technical analysts look at price charts, price patterns, volume data and derivatives of price (like momentum oscillators).
How does fundamental analysis work?
Fundamental analysis works by trying to identify the true, intrinsic value of global financial market asset or security. This is also known as the “fair value” or the “fair market value” of a financial market asset. As we have highlighted above, this requires analysis based on the information available and statistics evaluated. This could range from the huge amount of data on individual companies, the data from governments and supranational bodies on the performance of a national, regional or the global economy. Or it could be looking at scenario analysis for the impact of potential geopolitical events.
The fundamental analyst gathers all the information and data is deemed necessary and important that could influence the price of the underlying asset, then attempts to analyse this data with the objective of deciding on the at what price the asset should be trading. ten a trading or investment decision can be made, dependent on whether the current market price is above, or below this calculated, fundamental price.
Why is fundamental analysis important?
Fundamental analysis is important because it is used by many different financial market institutions as a core approach to identifying the “true market value” of any particular asset. Because long-term institutional investors such as pension fund, investment funds, mutual funds and life assurance companies use this approach, alongside shorter-term investors/ traders like hedge funds, then it is clearly an important measure of where a market is trading, and also could be trading in the future. Given that so many major market participants use this approach, and given their influence on financial markets, fundamental analysis is clearly important to the current and future price of any security or asset class.
When should fundamental analysis for use?
Fundamental analysis should be used when you want to decide on whether a broader financial market asset class, or an individual security is overvalued or undervalued. By its very definition, a fundamental analysis approach to markets looks to measure the “true” or “intrinsic” value of a security or asset by appraising all facets of the market. When using a fundamental analysis approach, it is possible to state when a market has been overstretched to the downside, therefore being undervalued, presenting a buying opportunity. Or is a market or individual security overvalued, hence overbought and should be sold.
Fundamental analysis advantages
There are many advantages to using fundamental analysis as an approach to analysing financial markets, making decisions about market direction and also possible timings of trade entry and exits.
As mentioned above, many of the major institutional players in the financial markets use a fundamental analysis approach to their investing and trading. It is therefore an advantage if you are following this analysis by industry leading analysts and are also able to add in your own analytical skills and judgements.
Fundamental analysis allows you to set realistic and attainable price targets for where a market should be trading, in respect of its “fair value”.
Fundamental analysis limitations
There are limitations to the fundamental analytical approach to financial markets. One of the major limitations being around trade entry/ exit timings and levels. Once any fundamental price target is calculated, when do you enter the investment or trade? Straight away? Do you wait until an event? And also, what price do you decide to buy or sell the market? Fundamental analysis does not really give you this information. This is where a combination with technical analysis can be useful.
Another limitation to the fundamental analysis is can be difficult to categorically decide when the fundamental view changes. If you have a long position and the price is going lower, but the fundamental view does not change, at what price level do you exit the trade if the fundamental view still tells you that the price should be higher? At some point, the loss may be too much.
Fundamental analysis examples
Let’s take a look at some examples of fundamental analysis.
- Macroeconomic fundamental analysis: Major economic data from a nation, a region or from the global economy are important fundamentals that can impact the price of an asset. These would include; employment and unemployment numbers, inflation rates, Gross Domestic Product data, Purchasing Managers Index surveys, trade data and much more.
- Geopolitical scenario analysis: Analysing the potential outcomes of a national election (like the US Presidential and Congressional elections) and the various scenarios that could occur during and after an election.
- Microeconomic, company analysis: The analysis of a whole host of data is possible from a fundamental perspective when it comes to individual companies. This would include; the company balance sheet, the income statement, the statement of cash flows, the credit rating, the management, director share holdings, corporate governance and much more.
The key takeaways from the fundamental analysis approach to analysing markets and trading are:
- Fundamental analysis is an important part of global markets pricing, used by a large section of key market participants.
- It is a valuable tool in seeing where markets are possibly undervalued or overvalued.
- It can be used in combination with technical analysis, or as a standalone approach on its own.
To further increase your trading knowledge check out our article on economic calendars, trading the news, financial events and analysing reports.
