Fundamental analysis is a method of researching financial markets by analysing economic, financial, and other fundamental factors influencing asset prices.
5 minutes for reading
What is fundamental analysis?
Fundamental analysis is a systematic approach used to determine the fair market value of assets and forecast their future changes. This method involves the study of financial reports, macroeconomic data, political and geopolitical events, weather conditions, major news events, and other factors that impact the prices of these assets.
Investors use fundamental analysis to evaluate the financial health of companies, market conditions and competitiveness, macroeconomic trends, and various other factors to make informed decisions about buying or selling assets.
It helps traders assess the fundamental value of a specific asset and determine whether it is overvalued or undervalued in the market. For example, if a stock is undervalued, traders may purchase it as they expect it to rise. If it is overvalued, they will likely consider selling the stock due to the potential for a price decline.
Fundamental analysis begins with gathering the necessary data. Next, the results obtained are assessed and interpreted. Analysts employ various methods, including comparative analysis and forecasting future trends.
Key components of fundamental analysis
The number of components may vary depending on the asset class:
- Companies’ financial reports (for stocks) – the balance sheet, income statement, and cash flow statement are analysed to understand the company’s financial health, income, expenses, and cash flows of the company
- Macroeconomic indicators (for currencies and bonds) – these include the country’s economic indicators such as GDP, inflation, unemployment parameters, and interest rates
- Commodity market reports (for commodities) – provide information on demand, supply, reserves, and production of oil, gold, metals, and other commodities
- Political and geopolitical events (for all asset types) – this category covers events such as elections, political and military conflicts, legislative changes, and other developments in the country that can influence the market
- Sector and industry analysis (for stocks and bonds) – this involves evaluating the competitiveness and trends in a specific industry in which the company operates
- Dividends and coupons (for shares and bonds) – this involves an analysis of the amount of share dividends and bond coupons and how stably they are paid
- Return on investment (ROI) and performance indicators (for all asset types) – this evaluates how efficiently the asset generates profit for the holder. It may include indicators like P/E (Price/Earnings) for stocks
- Competitor analysis (for stocks and bonds) – this involves studying other businesses in the same sector and their development strategies
Fundamental analysis rules
Fundamental analysis rules are key statements or principles that form the basis of this method. They help investors and traders better understand how fundamental analysis works and how it can be applied to decide whether to buy or sell assets. Some of the rules include:
- Market value reflects fundamental value. When an asset is undervalued, its price is expected to rise over time. Conversely, an overvalued asset is likely to see its price decline eventually
- Information affects prices. For example, financial reports or macroeconomic data impact investor decisions and, consequently, asset values
- The market reacts to news and developments. Notable events can lead to abrupt price fluctuations in the short term
- Fundamental factors shape long-term trends. This also means GDP, inflation, and production
- Diversification can mitigate risks. A diversified asset portfolio allows investors to reduce risks related to fluctuations in prices of some assets
- The evaluation of fundamental factors changes over time. This means reactions to economic, political, and technological changes
- Fundamental analysis helps in the long run. It can be advantageous to investors focused on long-term investing as it helps evaluate an asset's value in the future
- Market participants respond to certain cyclic events in the same way. For example, if a military conflict in the Middle East escalates, oil prices typically rise
- Not everything can be predicted. The economy may face force majeure events such as an air crash or a disaster at a nuclear power plant. Such events also have a significant impact on the prices of some assets
Fundamental analysis methods
- Comparison. Comparing market sizes and shares, company sizes, and various ratios characterising firms or shares
- Induction. Forming rules based on specific cases. For example, if a corporation’s results vary significantly by season, it may indicate a persistent seasonal factor
- Deduction. Applying a general rule to a specific case. For example, a drop in oil prices often leads to reduced earnings for oil companies. If stock exchanges experience declining oil prices, representatives of the oil industry are also likely to see lower earnings
- Correlation measurement. This measures how much asset prices or yields relate to each other and is expressed as a correlation coefficient. Values can range from 1 to −1. A coefficient near 1 indicates that the stock prices of correlated companies move in the same direction, while a coefficient near −1 suggests they move in opposite directions. A coefficient near 0 implies no significant relationship between the assets
Fundamental analysis stages
- Macroeconomic analysis.
- Industry analysis.
- Financial analysis of a company to determine the fair stock value.
- Comparison of the current stock value with the fair fundamental value.