Fundamental Analysis: Is It the Right Tool For You?

Q: What is Fundamental Analysis?

A: Fundamental analysis attempts to evaluate the intrinsic — or true — value of a company. This method aims to determine the "fundamental" strength or weakness of a company by reviewing a wide variety of company and economic data. Being armed with a well-researched estimate of a company’s value can help an investor decide if its stock is undervalued or overvalued.

Investors that undertake fundamental analysis believe that thoroughly understanding a company and creating an estimate of its value can lead to "buy low, sell higher" opportunities. Warren Buffett, well-known for his value-style investing success using fundamental analysis, explained the concept well when he said, "Price is what you pay, value is what you get." The idea is to pay a low price for something you believe has high value, in hopes the price will later rise.

What Are Fundamentals?

In order to estimate a company's intrinsic value, fundamental analysis takes into account a huge amount of data related to the company, its competitors, the industry and the broader economy.

The information analyzed can include:

• Economy. Local, national and global economic data, issues and trends that could impact the company's growth potential (e.g., interest rates, employment data, inflation, oil prices, etc.)
• Industry. Broader trends (e.g., technology, demographics, economy, energy, etc.) that could impact the industry as a whole and how the company is positioned.
• Competitors. The company's position in its industry and any sustainable advantage it has over competitors.
• Management team. The strength of the current management team and its history of successful use of capital toward growth.
• Financial statements. Intensive study of revenue, earnings, profit margins, cash flow, return on equity, etc.

Fundamental analysis can use a top-down or bottom-up approach. A top-down approach starts at the macro level (top of the list above) and works its way down to the company level. Alternatively, a bottom-up approach starts at the micro level (the bottom of the list) and works its way up to the global factors.

Who Uses Fundamental Analysis?

Longer-term investors tend to prefer fundamental analysis because it emphasizes the strength and long-term potential of a company. Value investors like Buffett base their buy and sell decisions on the intrinsic value estimates that they create using fundamental analysis.

Fundamental analysis differs entirely from technical analysis, which is based only on the stock's historical price and trading information, which is then used to find patterns and price trends. Read Technical Analysis: What You Need to Know to find out more.