What Is Fundamental Analysis and How Does It Work?

What Is Fundamental Analysis and How Does It Work?

Fundamental analysis is one of two major analysis approaches for interpreting financial markets. While technical analysistries to understand securities through past price and volume fluctuations, the fundamental analysis aims to assess a security’s intrinsic value via external influences.

The fundamental analysis employs financial, economic, and other non-quantifiable facts to find an asset’s intrinsic value that does not reflect in the current market price. One of the noteworthy things about this analysis method is that it can be applied to any asset, including all the financial products you can trade with, such as forex, cryptocurrency, and options.

Fundamental analysis is a broad approach that every trader must extensively understand to succeed in the trading market. That’s why this article is written to address everything you need to know about Fundamental analysis; continue reading to discover what it is, how it works, and many more.

Without further ado, let’s dive right into it!

First, What Is Fundamental Analysis?

The fundamental analysis estimates an asset’s economic, political, and social intrinsic value or ‘real value’ and evaluates the factors that could influence its future price. With technical analysis, traders get all the info they need to trade from charts, while fundamental traders use the external factors of price movements of the asset in question.

Fundamental analysts use financial statements, external factors and influences, industry trends, and market releases to calculate the asset’s value without considering the market value or sentiment.

Once a trader has determined a security’s intrinsic value and considered other vital factors, such information can be used to make investment decisions. For example, when an investor predicts that a security may be under or over-valued when evaluated by its fundamentals, this could be a sign to buy or sell.

Pros

  1. Fundamental analysis helps investors and traders to gather accurate information to make rational decisions about what position to take.
  2. Fundamental analysis seeks to understand an asset’s value for traders to take a much longer term in viewing the market; rather than establishing entry and exit points. Once the trader has determined a mathematical value for the asset, they can compare it to the current market price to evaluate whether the asset is over or under-valued to profit from the market change.
  3. Fundamental analysis is preferable for long-term investment.
  4. The more certified and prevalent the news source, the more effective it will be on asset value.

Cons

  1. Fundamental analysis can be time-consuming.
  2. Another drawback is that this kind of research does not always consider how market sentiment can affect prices; this means one could miss some profit opportunities.
  3. When conducting technical analysis, there are clear indicators of when to buy or sell, but the fundamental analysis doesn’t give such a bonus.
  4. Many short-term trading strategies and goals can’t depend on this analysis method as it mainly applies to long-term investment.

Understanding Fundamental Analysis: How Does It Work?

Fundamental analysis (FA) works on the understanding that an asset’s future potential should be based on more than just previous performance. Instead, it considers microeconomic and macroeconomic circumstances that may affect a specific market. As a result, it applies to virtually all assets, including cryptocurrencies.

Therefore, Fundamental analysis seeks to determine how external factors can influence a business or project’s performance – especially those that aren’t obvious. These considerations focus on less concrete and more theoretical aspects, such as a company’s leadership and how those leaders have executed other past company projects.

In other words, Fundamental analysis is based on the clue that each asset has a fair worth – and that while the markets may overprice or underprice an asset temporarily, its price should ultimately regulate that fair value. Simply put, FA is a technique that helps determine whether or not something is under or over-valued.

5 Tips on How to Perform Fundamental Analysis

Enough of theory; let’s break the fundamental analysis down into 5 tips:

1.      Find Credible Sources

Ensure you trust your information sources. For example, most companies make their financial statements public; you can get reliable info from this source. Also, you can get a catalog from most brokers. In addition, the U.S. Securities and Exchange Commission (SEC) is also a good source.

2.      Read The News

You want to know the public opinions about the company. Corporate marketing materials won’t give the clearest picture. Instead, get reviews and articles from reputable websites and publications, and look at social media to know the public perception of the companies.

3.      Run Background Checks

Not legal ones; investigate the company’s leadership. Find out where they worked before, the decisions they made on behalf of the company, and what the results were to know how efficient they are.

4.      Focus on Underrated Assets 

The key to fundamental analysis is to discover an asset that can outperform. Take, for instance, companies with great reputations that have been around for an extended period.

You want to be sure that the reason for a price reduction is a short-term thing and that you’re getting a great deal in the long run. 

5.      Believe Your Gut

Trading skill is your call, so you must develop an intuition for trading.

The Bottom Line

Fundamental analysis can be very beneficial, but it should be used cautiously. If you are reading a sell-side analyst research, knowing the analyst behind the report is essential. Of course, we all have our favouritisms, so every analyst has some prejudice. Although, nothing is wrong with this, and the research can still be of great use.

Therefore, study what the ratings mean and the analyst’s track record before you take drastic action. Press releases and corporate statements offer great information but should be read with a healthy degree of doubt to remove the truth from the hype.

Press releases don’t occur accidentally; they are an essential public relations (PR) tool for companies. But, overall, investors should become expert readers to separate the vital information and ignore the hype.

Still, have questions? Let’s have a chat in the comment session below.

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