Fundamental analysis definition

What is fundamental analysis?

Fundamental analysis is a method of evaluating the intrinsic value of an asset and analysing the factors that could influence its price in the future. This form of analysis is based on external events and influences, as well as financial statements and industry trends.

Fundamental analysis is one of two major methods of market analysis, with the other being technical analysis. While technical traders will derive all the information they need to trade from charts, fundamental traders look at factors outside of the price movements of the asset itself.

Examples of fundamental analysis

There are various tools and techniques that can be used for fundamental analysis, but they have been categorised into two types of fundamental analysis: top-down analysis and bottom-up analysis. Top-down analysis takes a broader view of the economy, starting with the entire market before narrowing down into a sector, industry and finally a specific company. Conversely, bottom-up analysis starts with a specific stock and widens out to consider all the factors that impact its price.

Most fundamental analysis is used for evaluating share prices, but it can be used across a range of asset classes, such as bonds and forex.

The tools that traders might choose for their fundamental analysis vary depending on which asset is being traded. For example, share traders might choose to look at the figures in a company’s earnings report: revenue, earning per share (EPS), projected growth or profit margins. While forex traders may choose to assess the figures released by central banks that allow insight into the state of a country’s economy.

Pros and cons of fundamental analysis

Pros of fundamental analysis

Fundamental analysis helps traders and investors to gather the right information to make rational decisions about what position to take. By basing these decisions on financial data, there is limited room for personal biases.

Rather than establishing entry and exit points, fundamental analysis seeks to understand the value of an asset, so that traders can take a much longer-term view of the market. Once the trader has determined a numerical value for the asset, they can compare it to the current market price to assess whether the asset is over- or under-valued. The aim is to then profit from the market correction.

Cons of fundamental analysis

Fundamental analysis can be time consuming, it requires multiple areas of analysis which can make the process extremely complicated.

As fundamental analysis takes a much longer-term view of the market, the results of the findings are not suitable for quick decisions. Traders looking to create a methodology for entering and exiting trades in the short-term might be better suited to technical analysis.

It is also important to consider the best and the worst-case scenario. While fundamental analysis provides a more well-rounded view of the market, it is possible for negative economic, political or legislative changes to surprise markets.