Candlestick Trading Blog

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Fundamental analysis is a widely used method in value stock investing that is based on the performance of a company and the economic situation in the country or countries in which the company is based and/or trades. All of the large investment houses such as Schroeders and JPMorgan use this approach as it is very good for the determining long term value of a share.

The Approach To Fundamental Analysis

The most common approach to fundamental analysis is known as the "top down" approach and comes in three steps:

1. Analysis of the macroeconomic environment in all of the relevant markets.

Indicators that investors may want to consider in their stock market strategies include productivity, GDP growth, exchange rates, interest rates, and inflation. First the investor must prioritize these indicators as well as others to choose which are more likely to have the greatest effect on the financial performance of the company.

For example, a company based in the United Kingdom but whose main markets are overseas may find themselves negatively influenced by the movements in the exchange rates. An investor must decide whether the company is prepared for these changes either by sufficient diversification across different countries or by hedging currency trading.

2. Second, investors should conduct industry analysis to gauge the relative health of the sector in which a firm is operating.

Factors such as growth in competition (both domestic and foreign), exit from and entry into the industry, stock price history, and sales are among those that need to be considered.

Investors should realize that just because an industry is not attractive, it doesn't mean there are no investment opportunities within the industry.

3. Finally, the performance of the firm needs to be analyzed carefully to determine whether true value really exists in the firm's shares.

An investor interested in long term investing must interpret the firm's published results in the correct manner. Results should be compared year to year to decide whether the firm is improving in the long term. For example, is performance cyclical or has the company seen profits grow at a consistent rate?

Other indicators include cash flow, the debt to equity ratio, dividend payments, and all the information that is found in the statements which can give a good prognosis regarding risk reward ratios and the company's future direction. The comparison of industries is a very useful tool in evaluating a company's growth potential.

In addition to the financial information, successful traders will investigate further to find out whether a company is sustainable and also has a competitive advantage. In order to do this, one must inquire if the firm has any core competencies that other firms in the industry don't have, such as superior managerial expertise and money management, exceptional reactionary abilities to changes in the market environment or high brand loyalty.

The Outcome of Fundamental Analysis

From the evidence gathered using the stock market investing advice above, an investor can get a good idea of the long term prospects of the firm's share price. An investor will use "intrinsic value" upon which to validate his or her decision.

Intrinsic value refers to what should be the "real" price of a company's shares and so if the intrinsic value is above the current market price, it indicates that an investor should enter a long position and vice versa if the intrinsic value is lower.

Fundamental analysis is primarily utilized to address the long term future share price of a company as it cannot account for short term stock volatility. To more accurately predict the short term price variations of a particular share, investors may wish to use technical analysis tools instead.