Why is fundamental analysis important and its objective?
There are many factors that affect the price of a stock in the securities market. Sentiments, liquidity, technicals are some factors that affect price. But above all, the most important factor that influences the price of a share in the share markets is the fundamentals of the company.
What is Fundamental Analysis?
Fundamental analysis is nothing but a method to examine the financial data of a company in order to arrive at its intrinsic value by analyzing various quantitative and qualitative factors affecting that stock.
In other words, fundamental analysis includes all the qualitative, quantitative, macroeconomic, micro-economic, and other financial and non-financial data in determining the fair value of the company. This fair value is then used to identify whether the company is overvalued or undervalued.
If the current market price is lower than the fair value (also called intrinsic value), then the company is said to be undervalued and vice versa.
Now, let’s see why fundamental analysis is important.
Fundamental analysis looks at various factors that affect the price of a particular share such as-
- Business model
- Industry in which company operates
- Competition the company faces
- Financial Statements
The central of all these factors is finding the value of the company.
Let us discuss what role fundamental analysis plays in finding that value.
- Management Evaluation
Management is like the soul of the company. It plays a very crucial role in the growth and success of a company. Fundamental analysis helps in understanding the structure of the management and how it has been performing over the years.
- Analyzing company’s strength
No matter how good or bad the management or other factors are, at the end of the day financial performance is what matters the most. Fundamental analysis is not a very easy task. People find it difficult to do a stock research.
Fundamental analysis is basically “thinking out of the box” with no predetermined parameters.
- Determining company’s ability to beat the competitors
Even if company’s financial performance is good, what more is to be seen is that whether the company is able to beat its competitors. If it is not able to outperform its peers, it will not be able to survive in the long run. This peer comparison can be done with the help of fundamental analysis.
- Determining fair value
With the help of fundamental analysis, one can easily determine the fair value of a company by carefully analyzing the past and present performance of the company. Fair value helps in deciding whether the company is overvalued or undervalued.
On the basis of this analysis, one can take decision on what action to take. Hence, fundamental analysis is important in stock picking.
- Predicting future price movement
Even before an investor looks at a company’s financial statements or does any research, one of the most important questions that should be asked is: ‘What exactly does the company do?’ This is referred to as a company’s business model- it’s how a company makes money.
Fundamental analysis scans the industry and the overall economy, hence forecasts the movement of the price of the security. Based on certain parameters, fundamental analyst tries to predict the future price.
Objectives and goals of Fundamental Analysis
Fundamental Analysis uses both past and present data
- Company stock valuation
- Projection on its business performance.
- Evaluate management and make internal business decisions
- Calculate a company’s credit risk
- Make financial forecasts
Management is the team of the company which steers it towards financial success. Even the best business model dooms if the leaders of the company fail to properly execute the devised strategies.
Management quality can be measured by various ways-
- Conference Calls
- Management Discussion and Analysis
- Ownership and Insider Sales
Fundamental Analysis helps you find answers of the following questions-
- Is the company actually making profits?
- Is the company able to pay their debts?
- Is the company able to beat its competitors? Etc.
In share market, it is very much possible that a stock may be technically not sound but fundamentally, the company is quite strong. Fundamental analysis helps in identifying such companies which have high potential for growth and returns in such investment is also very high. So, if you want to hold your investment in a company for a long period of time, then it is important to understand whether your investment in that company is safe or not. Fundamental analysis helps a lot in filtering out companies that are financially strong and will continue to stay so for a long period of time.