What is Fundamental Analysis in Investing?

What It's About

Fundamental analysis is the preferred approach of almost all serious investors, especially value investors, those who focus on identifying out-of-favor companies that trade for well below their fundamental value.

Fundamental analysis (sometimes abbreviated FA) is one of two major ways for investors to understand how stocks will move over time. Fundamental analysis starts with the understanding that a company’s underlying business performance is the long-term driver of its stock price. From there, fundamental analysts examine a company’s competitive position — its products, its financing, its growth rate, its profit margins, its competitors, and more — in order to predict how the business will perform in the future.

Fundamental analysis is the preferred approach of serious investors who focus on identifying out-of-favor companies that trade for well below their fundamental value.

The second major way to understand price movements is called technical analysis (sometimes called TA), a method that relies on tracking a stock’s past price movements in order to forecast where it will move in the future.

What does fundamental analysis actually analyze?

Fundamental analysts use any data about a business to understand how it is performing and how it might perform in the future. Analysts strive to determine whether a company has a sustainable competitive advantage — that is, a process or competitive position that allows the company to fend off rivals. A competitive advantage helps the company thrive in the future. These competitive advantages are a “holy grail” for investors.

The types of information that a fundamental analyst might try to understand include:

  1. Sales – Can the company keep up its sales growth? How will it do so?
  2. Margins – Will margins hold steady or will competitors erode them?
  3. Earnings – How much will earnings grow over the next one, three, and five years?
  4. Debt – Is the company’s debt load manageable? What happens in a recession?
  5. Products – How are the company’s products received in the market? What new products are on the way? Will they be successful?
  6. Finances – Does the company have enough cash? Is it able to negotiate favorable terms for financing?

This is only a sample of the kinds of questions that fundamental analysts ask, but they get to the heart of what the analyst wants to know: will the company thrive in the future and is it worthwhile to invest in?

Two major frameworks for fundamental analysis

Analysts have developed at least two major frameworks for systematizing their study of companies, and they’re useful tools for understanding a company’s competitive positioning.

The first is called the SWOT Analysis. The name stands for strengths, weaknesses, opportunities, and threats. While studying a company, the analyst can examine its position in these four areas:

  1. Strengths – What strengths does the company have and how can it bolster them?
  2. Weaknesses – Where is the company deficient and how can the company mitigate its weakness?
  3. Opportunities – Where does the company have a chance to improve or grow? Is there a new product or a new growth industry?
  4. Threats – From where will the company and its position be attacked or threatened?

The SWOT analysis provides a greater perspective on what the analyst sees happening in the company and industry. Is a new product playing off the company’s strength or does it fix a gap in its offering? Does the hiring of a new CEO allow the company to move into a new sub-industry or prevent a rival from encroaching on its territory?

The second major framework for understanding a company’s competitive position is called Porter’s Five Forces, a model developed by Michael E. Porter, a professor at Harvard University. It lays out five forces that impact every industry, so investors can understand its attractiveness. The five forces are:

  1. Threat of new entrants — How easy is it for new rivals to join the industry?
  2. Threat of substitutes – Can another product be substituted for the industry’s product?
  3. The bargaining power of customers – Can customers negotiate down prices easily?
  4. The bargaining power of suppliers – Can suppliers raise prices on the industry easily?
  5. Industry rivalry – How willing are the industry’s companies to fight each other?

Porter’s Five Forces is a tremendously helpful framework for considering how industry dynamics play into a company’s attractiveness as an investment. The best investments are found in industries with few new entrants, few substitute products, low bargaining power of customers and suppliers, and low industry rivalry. It’s rare to find industries that meet all these criteria.

Who uses fundamental analysis?

Fundamental analysis is the preferred approach of almost all serious investors, especially value investors, those who focus on identifying out-of-favor companies that trade for well below their fundamental value.

Warren Buffett, founder of Berkshire Hathaway and one of the most famous investors, uses fundamental analysis when deciding on his investments.

Berkshire Hathaway’s Warren Buffett, arguably the world’s most successful investor, is a noted fundamental analyst. But fundamental analysis is also used by hedge funds, investment banks, pension funds, individual investors, and any other kind of analyst who wants to understand the dynamics of an industry and how a company is likely to fare in the future.

Schism between fundamental analysis and technical analysis

While fundamental analysis is more often the tool of investors, technical analysis is more often the tool of traders, those who are looking to make a quick buck by moving in and out of the market in a relatively short time frame. These two schools of thought are often at odds over what moves stock prices, with technical analysts often criticizing fundamental analysts for being blind to what the charts are saying and fundamental analysts saying that technicians are using witchcraft by looking at past price movements.

By Mackenzie O'Connor
Wealthbase Contributor

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