There are an endless number of investment strategies, almost all of them involving the use of fundamentals. So what is fundamental analysis? It is a technique that attempts to determine a security’s value by understanding the underlying factors affecting the company’s business and its future prospects. This involves the consideration of both qualitative and quantitative factors. The ultimate aim of conducting fundamental analysis is to determine a security’s ’intrinsic value‘ – that is, the actual value of a company based on all tangible and intangible aspects of the business.
It should be noted, however, that all valuations are subjective in nature and that there is constantly a need to make subjective judgments. The uncertainty underlying fundamental analysis is that the intrinsic value attained is only an estimate, and it is unknown how long it will take (if ever) for the intrinsic value to be reflected in the market price.
By contrast, technical analysis focuses solely on the price and volume movements of securities. The assumption underlying this approach is that all relevant news about a particular company is already priced into its stock, and that its price movements provide more insight than the fundamental factors of the business.
There are also believers in the ‘efficient market hypothesis’ who dismiss both fundamental and technical analysis. The hypothesis contends that it is impossible to beat the market in the long-run as the market is efficient in pricing all stocks on an ongoing basis.
Although there are differing views and methods in identifying mispriced stocks, the importance of fundamental analysis should not be overlooked. Successful investors such as Warren Buffet, Benjamin Graham and Peter Lynch highlight that, although businesses and economic cycles can constantly undergo change, the underlying fundamentals to investing remain unaltered.
Often, the first step of fundamental analysis is to identify potential investment opportunities. This involves identifying both existing price disparities and future opportunities though the thematic research of macroeconomic opportunities, social and consumer behaviors . This funnel approach allows investors to filter and rank the potential opportunities that they wish to pursue.
It is only after opportunities have been identified that investors should proceed onto industry and company analysis. Further research is required to understand by what means the company generates revenue, and how the company is positioning itself to generate profits in the future in response to any changes in its competitive, economic and regulatory environment.
Part II of this series will cover more extensively the use of comparative company analysis as a method of determining whether a company is mispriced in comparison to similar firms.