What is Fundamental Analysis?

Every day, investors get various information, some of which reflect a company's fundamentals. People may pay attention to the growth rate of a tech company's revenue or its research and development results.

Unlike technical analysis, which relies on past prices and trading information to predict future price action, fundamental analysis attempts to determine a company's intrinsic value by analyzing data that is 'fundamental' to the company.

Understanding fundamental analysis

In business, the so-called fundamentals refer to the primary characteristics and financial data necessary to determine the stability and health of a target company. This data may reflect macroeconomic factors, sector/industry development, and the company itself. We can analyze and measure how these changes in fundamental aspects affect the company's performance and future stock price movement.

For example, suppose an electric-vehicle manufacturing company announces delivery delays repeatedly. In that case, people might have questions about its supply chain management or fault in its core technology. Therefore, investors might doubt the company's prospects in mass production, which is reflected in the declining price trend.

Top-down vs. bottom-up fundamental analysis

Fundamental analysis can be either a top-down or bottom-up approach.

• A top-down approach starts by analyzing macroeconomic factors, such as interest rate level and GDP growth rate, to determine the economy's overall status and direction. So, investors could identify which sector or industry will offer a better investment opportunity. For example, cyclical industries might bounce back at a relatively high speed when an economy is recovering from stagnation.
• Afterward, the investors would perform a more specific sector and industry analysis to assess the prospect and potential opportunities. At last, we will go into detail about companies within the most promising industries and select individual stocks.

• A bottom-up approach starts with an individual stock by observing its performance and studying its prospects instead of a general economic trend. This approach primarily focuses on microeconomic factors such as a company's earnings and financial data. Perhaps Warren Buffett is very proficient in the bottom-up approach. He has always looked for companies surrounded by an "economic moat," ensuring a consistently high return on capital.

Why use fundamental analysis

There is an age-old question: how much is the company worth?

The fundamental analysis seeks to answer the question above by calculating a target company's intrinsic value through fundamentals. Financial analysts and veteran investors build many valuation models based on fundamental factors. However, there is no universal standard, and we won't elaborate on the calculation here. Suppose we somehow get an evaluation result on a company's intrinsic value. Afterward, the intrinsic value is compared to its current market price to help with investment decisions assuming the price of a security will revert to its intrinsic value.

Case 1: The intrinsic value is above the market price. It means the security is currently undervalued and could be added or increased in the portfolio.

Case 2: The intrinsic value is below the market price. It means the security is currently overvalued and should be reduced or removed from the portfolio. Some aggressive investors might even short-sell the overpriced securities.

Quantitative and qualitative fundamentals

From Warren Buffett's October 1967 Letter to Partners: The evaluation of securities and businesses for investment purposes has always involved a mixture of qualitative and quantitative factors.

To help better understand fundamental analysis, we can generally classify the fundamental factors into two groups: quantitative and qualitative.

• Quantitative fundamentals refer to the information shown in numbers and amounts, such as the revenue or EPS of a company.
• Qualitative fundamentals describe the nature or standard of something rather than its quantity, such as brand loyalty to a company.

Let's explore more about the quantitative and qualitative fundamental analysis!