Back to basics: What is fundamental analysis?

Fsp Invest, 11 Dec. 2013

Tags: fundamental analysis, what is fundamental analysis, top down strategy, bottom up strategy, investing, researching shares, warren buffett,

When it comes to investing, there are two main types of research investors use. One is fundamental analysis and the other is technical analysis. Fundamental analysis is hugely popular in the various forms it comes in. Investor great Warren Buffett uses fundamental analysis as part of his research for selecting companies to invest in. Let’s take a closer look at what fundamental analysis is…

Fundamental analysis can serve as the foundation for your investment decisions, Gareth Stokes in Fear, Greed and the Stock Market explains…

To excel in this field, you need to get as much information as possible about a companies’ revenue, expenses, assets and liabilities. And you also need a good understanding of the prevailing domestic and global economic conditions.

You can divide fundamental analysis into two schools:
  • Top down analysis; and
  • Bottom up analysis.
These strategies are part fundamental analysis and part environmental scanning.

The top down strategy

This strategy starts with a thorough scan of the prevailing environmental conditions.

You should complete this analysis by considering the impact of factors, including:
  • Interest rates;
  • Inflation;
  • Consumer confidence; and
  • Employment numbers.
In other words, you start with a broad overview and then work down to a specific share pick, hence the name top down.

Once you’ve got a grasp of the overall economic picture you can decide which sectors and industries you should invest in.

Your last function using this technique will be to perform a fundamental analysis (through calculating key ratios and analysing the financial statements) on the share you’ve selected. If this analysis reveals a problem, then you should take a step back and select the next viable share from the same sector.

The bottom up strategy

This strategy makes use of the fundamental techniques as applied to a specific company. You discard all your views on the general economic environment and which sector you’d prefer and focus instead on the company’s fundamentals.

Once you’ve found a company which looks good based on this intense analysis of financial statements and ratios, you’re ready to broaden your view.

At this point you zoom out and consider the intricacies relating to the particular company. You’ll consider the company’s management, earnings, growth prospects, etc.

Your aim using this investment strategy is to find the single firm in a sector that will beat its peers hands down.

So there you have it, what fundamental analysis is.

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