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What is fundamental analysis? Explanation for newbies

Updated on March 10, 2024

February 18, 2022

Which stock to invest in? Such a question is asked daily not only by novice investors, but also by experienced professionals. Trading on the stock exchange is not just like that. If you decide to evaluate your savings, you should first make a good decision whether you are making the right decision. It may simply happen that the stock you bet on will not bring you the desired profit. It can even bring you a loss. So how to make a good decision? If you are not a psychic, it is good to think everything in advance. This of course involves good market analysis. And there are several ways to help you with this. Technical analysis is among the most common. It bets on the development of the company’s price in history. Then there is fundamental analysis, which examines the intrinsic value of a security, among other things. Let’s introduce her.

What is Fundamental Analysis

Fundamental analysis is one of the basic concepts for trading on the stock market. Therefore, it is one of the things that you should familiarize yourself with even before you start trading. Just like technical analysis, it will help you to make a better decision whether to invest in a given security or not. Therefore, study it well. In addition to educational articles and videos, setting up a demo account will certainly help you.

You can do so with the vast majority of brokers. In addition, many of them are free of charge. After logging in and creating a demo account, you will receive some amount of money that you have “invested”. Virtually only of course. You can then practice technical and fundamental analysis here for a certain period of time. You will thus gain practical experience, which can be very useful for you in the future.

Thus, fundamental analysis is a method of market research. It focuses on researching the intrinsic value of a security, but also includes a broader analysis of macroeconomic and microeconomic indicators. She will therefore be interested in the economic and political situation in the world, or in a specific region.

It will also take into account indicators such as GDP , inflation or perhaps the development of energy prices. It tries to find out the real price of the share in the market. In this way, the trader can learn whether the securities are undervalued, overvalued, or whether they are valued fairly. This will help you not only to decide to enter the investment. At the same time, it will tell you when it is a good time to enter. And of course, this can bring you better returns when trading on the stock market.

How to proceed with fundamental analysis

When doing market research, you will soon find that it is a good idea to combine both mentioned procedures. Therefore, both technical and fundamental analysis will be helpful to you. Why? The answer is simple. Both approaches are simply complementary. However, their use will probably be reflected depending on whether you are an intraday trader, i.e. you close trades within a short period of time, or you are more likely to bet on long-term investments. If you are doing day trades, you will be better informed by technical analysis. As a specialist in long-term investments, you will be more interested in fundamental analysis.

There are two possible ways you can proceed with market research. Again, it will depend on how long you close the trades. Of course, this may not always be the case. Simply choose the method that suits you better. A “top-down” approach is more typical for intraday traders.

This involves first a broader analysis of the global situation. Based on this, you will decide to invest in a share of a company from the region or an industry that appeals to you. From this, you will subsequently draw several suitable candidates. And you will focus on them closely. Here you can already operate with technical analysis, which will tell you about the price development of the security. Based on this, it is then possible to better estimate how the price will develop in the future. Or, even in this final phase, fundamental analysis will be helpful instead of technical analysis. The decision is up to you.

The opposite process is “bottom up”. And it will probably suit more long-term investors. The procedure is completely opposite. Research therefore begins with specific companies that the investor has chosen. Subsequently, it moves to the analysis of the sector and region in which the companies are located. This is so that he knows what their potential is. This includes comparisons by other companies. Finally, there is a global analysis and research on what the company has the potential to break into the world.

Difference between fundamental analysis and technical analysis

The difference between these two main approaches to market research is obvious. Technical analysis only works with numbers. It is based on the historical development of the security’s price in the past and assumes that there are certain regularities in it. A graphical representation of the security’s price development helps with this. It is in him that technical analysts look for these regularities. They are not interested in more general data related to politics and the economy. They expect that all these indicators are included in the resulting price of the company’s share.

In contrast, fundamental analysis is based on a broader framework. This means that it analyzes the global situation, the industry in which the company operates and its region. Based on this, the intrinsic value of the share is revealed. According to fundamental analysts, it is not enough to make an investment decision simply by following the development of the price in the past. All important factors are not included in them.

Graphs shape the relationship between supply and demand. This means that they take into account the current mood of the market. Fundamental analysis misses that. It is therefore ideal for investors who bet on long-term investments. They determine the development potential of a certain company for the future, not just for the next few hours. Important indicators include, for example, the company’s profits, expenses and liabilities.

However, as we have already mentioned, both methods complement each other, which is why many investors use a combination of both of them when trading on the stock market. They also have in common that they can be used for several markets. In this article, we are mainly talking about stocks, but keep in mind that both technical and fundamental analysis can be used not only for researching stock markets. You can also use them on Forex, when trading on the stock exchange with commodities and cryptocurrencies.

Intrinsic value of the stock

The intrinsic value of a stock should be what you arrive at using fundamental analysis. Specifically, it is the determination of the current price of a security at which it should be traded at a given time. This usually does not correspond to the results of technical analysis, as it is influenced by the resulting ratio between supply and demand in the market. We arrive at it on the basis of a broader market analysis, where we include the global and regional economic and political situation, the profits and expenses of the company, down to such trifles as energy prices. We can include, among others, the management of a company whose intrinsic share value we are interested in.

However, each trader has his own procedures for fundamental analysis and may use different sources. This is why the resulting intrinsic value of a stock is often subjective. Therefore, two investors do not always have to agree on the real value, and therefore their resulting decision to make the investment is different. We should also note that all these indicators are variable over time. What applies one year does not necessarily apply the next.

There may be a change in the management of the company, it may happen that the economic situation of the given country changes… Anything can happen. Therefore, you should take into account that it is not enough to perform the fundamental analysis for one security share only once. It needs to be done repeatedly. Especially if you focus on long-term investments. On the contrary, if you are an intraday trader, you can count on more stable results.

Qualitative and quantitative fundamental analysis

Unlike technical analysis, fundamental analysis relies on both qualitative and quantitative indicators. This also shows the complex nature of her research. It takes into account a wide range of facts to help you evaluate the situation and make a really good decision. At the same time, technical analysis bets only on current quantitative trends between demand and supply. However, it cannot be said whether it is better to deal with quantitative or rather qualitative matters. Again, their combination is best.

First, to clarify, let’s explain what it actually is. If we talk about quantitative indicators, we will have different numbers and statistics in mind. An example of this can be the company’s profits and expenses, but also its obligations to other companies. Financial statements are usually the source of such information. So we see that fundamental analysis draws on publicly available information.

The same is true of its qualitative part. However, there are no numbers involved here. On the contrary, it considers different standards and compares them with other companies. It can also take into account the political and economic situation. It often draws on news and information that is available about the industry and region. These resources may vary from analyst to analyst. Likewise, their evaluation of the situation may differ. The consequence is that they decide to invest in another security.

Fundamental analysis and qualitative aspects

The basic qualitative indicators that fundamental analysis takes into account include, among others, the customer base, regulation in the given industry and region, and competition. But there are many more. We will now imagine four basic circuits. These should be of interest to you when analyzing the market.

Business Model – You should first find out exactly what the company does and how it does it. You should know exactly what he does business with, what services he offers and what type of customers he targets. At the same time, you should make sure that it is viable. If her ideas are feasible, or if there is a possibility that her products will succeed even beyond the borders.

Competitive Advantage – Of course, it’s better to be a shareholder in a large company. Above all, a multinational corporation whose products are known all over the world. It says something. The company is developing well and its profits are high. And that is thanks to the fact that it is far ahead of competing businesses. The shares of such a company can promise you high rewards in the future.

Business management – ​​Even the best business strategy can fail due to insufficiently skillful business management. You too have the opportunity to see from publicly available information whether the current management of the company can implement it correctly. Just research the company’s website and then just google it. Are the people who are at the head of it experienced enough? What is their CV? Can you trust them? You can find that out too.

Corporate Governance – This is the way in which relationships between management, its shareholders and other stakeholders are maintained in a company. Each company adjusts them according to its own. However, they must take the law into account. He often regulates some of these relationships himself. Always choose a company where the company’s management respects the rights of shareholders and follows its own regulations.

Quantitative aspects

As we have already mentioned, proponents of quantitative fundamental analysis obtain information from the financial statements. Among the most important are balance sheets, profit and loss statements and cash flow statements. Let’s introduce them one by one.

Balance sheet – It is an indicator that tells us the real assets of the company on a certain date. This can include cash, land and tools. The financial amount that the company has invested in its own operation is also taken into account. We also have to take into account the obligations that the company has towards other companies. Based on the balance sheet, it is easy to find out whether the company is financially healthy, i.e. solvent in relation to its requirements. You will also find out how it is with profits and also easily calculate your profit on dividends.

Profit and Loss Statement – ​​The profit and loss statement is calculated for a specific period. We can therefore calculate this value for a single day or a week. However, companies usually publish it quarterly. It indicates how much the company gained in the examined period and how much money it lost.

Overview of cash flows – As the last of the indicators published in the financial statement, you will be interested in the overview of financial flows. According to him, you will find out in more detail what the company put the money into and where it received it from. You will be particularly interested in what profit the company is able to generate. Next, how much money the company will use to repay the claim. And also how much, on the contrary, it will receive if another company repays its claim.

Dividend yield of the stock

When deciding to buy a certain security, the dividend will certainly help us. Above all, if we are planning a long-term investment in the company. First of all, we should know what it is actually about. A stock’s dividend yield essentially reflects the profit an investor will receive for holding the security. When buying each stock, the investor should have the dividends listed as a percentage of the stock price. The company always pays them out to its shareholders over a certain period of time. Their amount depends on the size of the company and also on its profits.

When buying a security, you can choose between two variants. You either become a normal or a preferred shareholder. Both options have their advantages and disadvantages. Preferred shareholders have the advantage that dividends are usually paid to them first. That’s because they have a guaranteed fixed amount. Only then are they paid out to ordinary shareholders. But the disadvantage is that, unlike ordinary shareholders, they do not have the right to make decisions about the future of the company. This benefit accrues to ordinary shareholders. The weight of their vote then depends on the number of shares they own. The more, the more decision-making power.

Investing based on dividends?

It should be noted that the joint-stock company is not obliged to pay this dividend. It is only their decision. So, for example, if they don’t have any profits for the accounting period, they can choose not to pay them out. The same situation can arise if the company decides to invest funds for its own development or investment. At this point, you won’t receive any dividend, but the intrinsic value of the company’s stock will rise. And it can mean a higher dividend for you in the future.

The amount of dividends is not always the same. For growing and prosperous companies, they can rise over time, on the contrary, for declining companies, they can gradually decrease. Therefore, it is not always the wisest idea to make decisions based only on the current price of a security. Likewise, it may not be worthwhile to buy shares of a company that has the highest percentage of dividends. Such companies usually do not invest in their development. This tells us that their level is unlikely to grow in the future.

This is precisely why it is not advisable to orient yourself solely on the basis of technical analysis. It will show us the current price of a security and help us predict its value in the future. However, it cannot reveal what the intrinsic value of the stock is. On the contrary, fundamental analysis will help us with this. Thanks to it, we can better reveal the company’s potential compared to other companies in the given industry and region. Or also whether it has the potential to grow.

Of course, this is especially true for long-term investors. If you trade any securities at short intervals, you probably won’t care much about the evolution of the company’s intrinsic value. In both cases, however, we recommend considering a combination of both methods. They complement each other. It could pay off for you, what do you think?

Models for fundamental analysis

Investors use several models for fundamental analysis when trading the stock market. Each of these models shows different values. Each of them works with different indicators. It depends on your decision who you will work with. however, choose the ones that you consider important. Among the most used models are dividend discount, profit, cash flow and balance sheet models. What are the individual types?

Dividend Discount Models (DDM)

If you decide to trade in the stock market using the dividend model, you will be interested in what financial gain you will get. Long-term traders will be interested in the amount of dividends. The short-term profit is based on the movement of the price level of the share.

As you already learned today, the amount of dividends is not always the same. That is why there are several dividend models. These take into account whether the amount of dividends is increasing or not. Even so, it is more worthwhile to use them if the company’s dividend payments to shareholders are stable. This means that the company pays them regularly and they are more or less the same amount.

Profitable models

The profit model, in contrast to the dividend one, calculates with a net profit. According to some analysts, this corresponds better to the intrinsic value of the company. They are most often based on the P/E ratio . It is a value that simply determines the investor’s return. It says how many times the trader wants to invest in the given share of his net profit from the security. It is generally stated that if the P/E value is lower than 15, the security is worth buying. If, on the other hand, its price is higher, it is a good time to sell it. It is overpriced at the moment.

However, there are other profitable models that are based on other indicators. For companies with stable capital, we can use the P/BV indicator. It tells us how many currency units the investor is willing to pay for one currency unit that the company owns. There is also a P/S indicator. This, in turn, shows how many currency units the merchant wants to pay for one currency unit of business revenue.

Cash flow modely

You must have noticed that both the discount and profit models count only on the profits of the shareholders. So, if you would like to include the income of the company you are going to invest in, cash flow models are the right choice. We have already mentioned cash flow. This model also takes into account the capital that remains inside the companies. The company can do whatever it wants with it. This increases the intrinsic value of the share.

Balance models

This type of model is based on a balance sheet. And it can serve as an additional way of determining the value, for example, for the dividend model. It works with the accounting value, from which we can then calculate the B/P indicator. It also takes into account the liquidation value. This means the profit for the shareholders should the company decide to go out of business. After that, it would have to divide its assets among the individual shareholders. This also includes, for example, substantial value. We get this if we convert the book value to current market prices.  

Technical vs. fundamental analysis

Similar to technical analysis, fundamental analysis also has many pros and cons. Compared to technical analysis, however, it has one huge advantage. And that is taking into account the market as a whole. Her research has a wide scope. From macroeconomic to microeconomic indicators. Technical analysis, on the other hand, cannot process such a large amount of information because it simply operates only with numbers. Specifically, with the movement of the price level of securities.

Another advantage is that it can be used in several types of markets. So if you don’t focus on just one and understand it well, you can make a dent in the world of cryptocurrencies, commodities, stocks and the forex market with it. It can then predict with fairly good accuracy whether your invested money will return. But keep in mind that it will take some time to create quality fundamental analysis. It’s not like technical analysis, where you enter a few variables and you have a calculation. Moreover, if you prefer long-term investments, you should renew it regularly. The market situation is constantly changing. So don’t forget that.

So technical or fundamental analysis?

Although fundamental analysis offers a comprehensive market analysis, it does not hurt to supplement it with research using technical analysis. If you master both and then connect them, you can’t go wrong. But beware, it is not a rule. Neither scholar fell from the sky, so try both first with a demo account. This will give you more time to get to know them. This will then help you achieve a better result.

And maybe you will already create your own strategy for trading on the stock market while investing. The worst thing you can do is copy other traders. Everyone has their own understanding and prefers other indicators. Based on whether you are an intraday or long-term investor, put together your own market analysis process. Trust me it will pay off. So technical or fundamental analysis? The answer is simple. Preferably both.

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