Quick Answer
Fundamental analysis evaluates a company's intrinsic value by examining financial statements, management, competitive position, industry conditions, and economic factors. The goal is deciding whether a stock is overvalued, undervalued, or fairly valued. It answers what to buy, not when to trade.
Technical analysis, covered in the previous lesson, ignores the company entirely. Fundamental analysis is its mirror image: it builds a case for a stock's worth from the company's own numbers and its economic surroundings, not from a price chart.
What Does Fundamental Analysis Evaluate?
- 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
Which Financial Ratios Does the Exam Test?
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.
Top-Down or Bottom-Up: Where Does the Analysis Start?
| 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
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.
How Do Technical and Fundamental Analysis Compare?
| 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
- 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.
What Should You Check on Exam Day?
- Match the analyst's activity to the method: ratios and financial statements point to fundamental analysis, charts and volume point to technical analysis
- Never judge a P/E ratio in isolation; compare it to peers or the stock's own history
- Remember both top-down and bottom-up are fundamental approaches that only differ in starting point
- Keep intrinsic value as the fundamental analyst's core objective, something technical analysis never attempts