Fundamental Analysis
Now that you understand technical analysis focuses on price patterns, fundamental analysis takes the opposite approach: it digs into the company itself to determine what a stock is truly worth.
Core Philosophy
- Fundamental analysis evaluates a company's intrinsic value by examining financial statements, management quality, competitive advantages, industry conditions, and economic factors
- Goal: Determine if a stock is overvalued, undervalued, or fairly valued relative to its current market price
- Focuses on what to buy (value identification), not when to trade
Key Financial Ratios
Fundamental analysts rely on financial ratios to assess a company's health and value:
| Ratio | Formula | What It Measures |
|---|---|---|
| Price-to-Earnings (P/E) | Market Price / Earnings Per Share | How much investors pay for each dollar of earnings |
| Price-to-Book (P/B) | Market Price / Book Value Per Share | Whether the stock trades above or below its accounting value |
| Debt-to-Equity | Total Debt / Total Equity | Financial leverage and risk |
| Current Ratio | Current Assets / Current Liabilities | Short-term ability to pay obligations |
| Return on Equity (ROE) | Net Income / Shareholders' Equity | How efficiently the company uses shareholder capital |
- A low P/E relative to peers may suggest a stock is undervalued
- A high debt-to-equity ratio indicates greater financial risk
- ROE measures management effectiveness at generating returns
Exam Tip: Gotchas
- P/E ratio alone does not tell you if a stock is a good buy. You need to compare it to industry peers or the stock's own historical range.
Two Approaches to Fundamental Analysis
| Approach | Starting Point | Process |
|---|---|---|
| Top-down | Macroeconomic outlook | Economy -> Sector -> Industry -> Company |
| Bottom-up | Individual company | Company financials -> Industry position -> Economic context |
- Top-down: An analyst who starts by evaluating GDP growth, interest rates, and inflation before narrowing to specific sectors and companies
- Bottom-up: An analyst who starts by finding a company with strong earnings and low debt, then checks whether the industry and economy support that company's growth
Technical vs. Fundamental: Side by Side
| Feature | Technical Analysis | Fundamental Analysis |
|---|---|---|
| Focus | Price and volume data | Financial statements and economic data |
| Goal | Market timing (when to trade) | Value identification (what to buy) |
| Intrinsic value | Does not attempt to calculate | Core objective |
| Time horizon | Typically short-term | Typically long-term |
| Key tools | Charts, patterns, indicators | Financial ratios, valuation models |
| Key assumption | All info is already in the price | Market price can differ from true value |
Exam Tip: Gotchas
- The exam may describe an analyst's activities and ask which approach they use. A top-down analyst starts with the economy; a bottom-up analyst starts with company-specific financials. Both are forms of fundamental analysis, not technical analysis.
- Fundamental analysis finds what a stock is worth; technical analysis finds when to trade it. If a question describes someone studying financial statements, that is fundamental. If they are reading charts, that is technical.