Methodology

Stocks

Module 5

What is a portfolio?

Fundamental analysis

In contrast to technical analysis, fundamental analysis determines the value of a stock, based on the underlying performance of the business.

Investors that follow fundamental analysis believe that the successes or failures experienced by the business will have the biggest impact on the performance of its stock price.

If the business grows over time, fundamental analysts believe that this will result in the stock price of that company increasing too.

At the same time, if the business fails to perform well and faces difficulties, it is thought that this will have a negative impact on the stock price of the company.

Fundamental analysts try to value the underlying business of a stock, to see if the stock price is under-valued or over-valued.

If the investor believes that the value of the underlying business is much higher than the market value (market capitalisation), then they would view this situation as a buying opportunity. 

What information is involved in fundamental analysis?

In order to fully investigate whether a stock is over-valued or under-valued, both qualitative and quantitative information will be used.

When it comes to qualitative information, fundamental analysts will consider if the business model of the company is appropriate, if the company has any competitive advantages, whether the management are suitable to run the business well and if the company has policies that maintain relationships with all stakeholders.

When it comes to quantitative information, fundamental analysts will consider the strength of the balance sheet of the business, the quality of the income statement and the growth of the cash flows of the business (both inflows and outflows).

Fundamental analyst will consider both qualitative and quantitative information equally, in order to build a full picture of the business.

This will then be used to calculate the value of the business, which will then be compared with the market capitalisation, to see if it is under-valued or not.

Assumptions and criticisms of fundamental analysis

The concept of fundamental analysis is based on a number of assumptions. Firstly, it assumes that the stock price of a company does not necessarily reflect the true value of the business and that fundamental information is more accurate.

In addition, another assumption of fundamental analysis is that stock prices will reflect the fundamental value of the company over time. Therefore, if a business grows very aggressively, it is believed that this will be reflected in the aggressive growth of the stock price over time.

A criticism of fundamental analysis is given by those who believe in technical analysis, as they believe that stock prices already account for fundamental information. Therefore, they believe that stock prices cannot be under-valued or over-valued, with the stock price always reflecting the true value of the company.

As a consequence it is believed that analysing fundamental information is a waste of time.

Whether you follow the philosophy of technical analysis or fundamental analysis is a personal choice, it ultimately depends on what works for you.

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