Business, Legal & Accounting Glossary
Fundamental analysis attempts to find the actual value of a stock — ie, its ability to generate future cash flows — to make investment decisions. Fundamental analysis thus focuses on a company’s financial results. Specifically, fundamental analysis emphasizes forecasts of a company’s earnings and revenue growth rates, valuation ratios like price to earnings, and financial ratios like profit margins. Fundamental analysis also looks to conditions in the industry sector(s) in which the company operates and the broader economic outlook. Fundamental analysis stands in stark contrast to technical analysis, which ignores company fundamentals and looks only at the movement of stock prices and market activity. Both fundamental analysis and technical analysis have their doctrinaire adherents who consider the opposing approach useless. Most market pros, however, recognize that both fundamental analysis and technical analysis have their role in forecasting stock prices.
At one point or another, you may have heard an analyst say that before buying a stock, you should always “check the company’s fundamentals.” Much like a mechanic needs to check under the hood to verify the health of a car, fundamental analysts must examine several important details when trying to figure out the true value of a stock.
Unlike those who practice technical analysis or momentum investing, fundamental analysts try to size up a company’s condition and prospects by digging through its cash flow statement, balance sheet, and income statement, as well as its management, industry, competitive advantages, and risks. They’ll look at factors such as sales, earnings, and cash flows, and then process all of this information to determine the stock’s supposed true worth, or intrinsic value. Their belief is that even though this number might be very different from the stock’s current price, the market will eventually realize this discrepancy, and as a result, it will correct the stock price to reflect this intrinsic value.
It’s for this reason that a $0.50 stock could be very “expensive,” whereas Google shares were a dirt-cheap giveaway at $100. If you’ve checked a company’s fundamentals and found that its current share price is a lot lower than the intrinsic value you’ve calculated, you may have a bargain on your hands.
Of course, an estimate of intrinsic value is simply that: an estimate, and not something set in stone. But investors such as Warren Buffett have proved that it can be a very effective (read: profitable) way of valuing a business.
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This glossary post was last updated: 6th August, 2021 | 11 Views.