Features of fundamental analysis, Top-down vs. Bottom-up fundamental analysis

13/10/2022 0 By indiafreenotes

Fundamental analysis (FA) measures a security’s intrinsic value by examining related economic and financial factors. Intrinsic value is the value of an investment based on the issuing company’s financial situation and current market and economic conditions.

Fundamental analysts study anything that can affect the security’s value, from macroeconomic factors such as the state of the economy and industry conditions to microeconomic factors like the effectiveness of the company’s management.

The end goal is to determine a number that an investor can compare with a security’s current price to see whether the security is undervalued or overvalued by other investors.

Fundamental analysis assesses a company’s potential based on financial and non-financial data to obtain the fair value of its security, stock, bond, or derivative. It is a powerful tool for investors and stakeholders to understand the growth prospects and financial health of a company. Therefore, it is one of the most effective ways to evaluate investments.

It involves examining every aspect of a company’s operations through its balance sheet, past performance, financial reports, even market goodwill, management, and consumer behavior to arrive at the intrinsic value of its securities.

The analysis begins from macroeconomic factors such as the economy and industry performance and goes down to microeconomic factors like management, strategic initiatives, and business policies. Note that the analysis can also start at the microeconomic level and then move to macro components.

On conducting Fundamental analysis, if an investor deduces that a stock’s intrinsic value is greater than its market price, it means the stock is undervalued. In that scenario, the investor buys such stock and holds it until the market price reaches the intrinsic value. Then, the investor makes a sizeable profit on selling at intrinsic market price.

Similarly, an investor may decide to sell or refrain from buying an overvalued security. Being overvalued means that the stock’s intrinsic value is less than its market price. Thus, FA may guide investors to manage risks and make informed investing decisions by ascertaining the intrinsic value of a stock. Financial ratios calculated using data from the financial statements are the primary tool of FA.

Blindly investing in stocks without conducting FA may result in major losses, as revealed by the dot-com bubble in 2008-09. Thus, investors should employ fundamental analysis to make conclusions about companies and their securities. However, in practice, it should be used in conjunction with another process called technical analysis.

The technical analysis

Involves closely observing the stock price movements to predict the future and make investment decisions. It depends on past trends, stock charts, and price history to look for stocks that may perform better in the long run. Hence, technical analysis can be called the fundamental analysis of the stock market.

Types of Fundamental Analysis

Qualitative analysis

Qualitative analysis involves the study of a company’s goodwill, consumer behavior, demand, and company recognition in broader markets. It aims to unearth answers to questions like how it is perceived, how management decisions or announcements create a buzz in the market, and how it is different from its substitutes. In addition, its brand value and other common factors depict its socio and economic position in the market.

Quantitative analysis

Quantitative analysis is inclined towards statistics, reports, and data. It is solely based on its financial statements, quarterly performance, balance sheets, debt, cash flow, etc. It involves analyzing numbers, ratios, and values to understand the price of the shares and the company’s overall financial health.

Steps to do Fundamental Analysis

Two approaches are generally used in performing FA of a company:

Top-down approach

In this approach, experts start from macroeconomic factors assessing the economic and industry first. Then, they come down to market conditions and ultimately to evaluating a company’s progress, management, and other microeconomic factors.

Bottom-up approach

This approach is the vice versa of the top-down course. It starts with studying the company, digging up its record and performance, and then slowly moving upwards to macroeconomic factors like industry conditions and a country’s economy.