Fundamental analysis is the examination of the underlying forces that affect the well-being of the economy, industry groups, and companies. Fundamental analysis is the examination of the underlying forces that affect the well-being of the economy, industry groups, and companies.
At the company level, fundamental analysis may involve examination of financial data, management, business concept and competition. At the industry level, there might be an examination of supply and demand forces for the products offered. For the national economy, fundamental analysis might focus on economic data to assess the present and future growth of the economy.
These are the primary factors to consider when conducting fundamental analysis:
- What is the company’s revenue?
- Is it growing?
- Are they making a profit?
- Are they increasing indebtedness or paying off debt?
- What are their turnover rates?
- Does management take care of employees?
First and foremost, in a top-down approach would be an overall evaluation of the general economy. The economy is like the tide and the various industry groups and individual companies are like boats. When the economy expands, most industry groups and companies benefit and grow. When the economy declines, most sectors and companies usually suffer.
If the prognosis is for an expanding economy, then certain groups are likely to benefit more than others. An investor can narrow the field to those groups that are best suited to benefit from the current or future economic environment. If most companies are expected to benefit from an expansion, then risk in equities would be relatively low and an aggressive growth-oriented strategy might be advisable. A growth strategy might involve the purchase of technology, biotech, semiconductor and cyclical stocks. If the economy is forecast to contract, an investor may opt for a more conservative strategy and seek out stable income-oriented companies. A defensive strategy might involve the purchase of consumer staples, utilities, and energy-related stocks. Once the industry group is chosen, an investor would need to narrow down the list of companies before proceeding to a more detailed analysis.
With a shortlist of companies, an investor might analyze the resources and capabilities within each company to identify those companies that are capable of creating and maintaining a competitive advantage. The analysis could focus on selecting companies with a sensible business plan, solid management, and sound financials. After all is said and done, the investor will be left with a handful of companies that stand out from the pack.
WEAKNESSES OF FUNDAMENTAL ANALYSIS
- Time consuming
- Industry / Company specific
- Analyst bias