Merits And Demerits Of Fundamental Analysis: Fundamental analysis focuses on understanding the workings of a business at its most basic (i.e., fundamental) level. This analysis studies the relationship between a company’s share price and several other aspects of its financial position and performance.
Even though the data used is, by and large, historical, the analysis is forward-looking. The primary objective of this analysis is to examine a company’s intrinsic value or growth prospects.
Later on, intrinsic value is compared to the current market price of the company. If the current market price of that share is less than the intrinsic value, then the stock is called undervalued.
Fundamental analysis is sensitive to several factors, some of which are outside the control of the company’s management. For example, interest rates, GDP numbers, employment data, etc.
Some individuals combine fundamental analysis with ratio analysis. Forecasting relevant ratios is very important as it can help in determining the financial health of the company. Before getting into the merits and demerits of fundamental analysis, let’s first understand what is fundamental analysis.
What Is Fundamental Analysis?
Fundamental analysis focuses on both macroeconomic and microeconomic factors which can affect the share price. In comparison to technical analysis, which only covers the historical price movements, the fundamental analysis considers the company’s financials.
Apart from this, it also covers related economic factors to calculate an intrinsic value. Ultimately, investors can decide whether it is profitable or not to invest in the company.
Types Of Fundamental Analysis
Fundamental analysis is divided into 2 categories: Quantitative and Qualitative. Quantitative fundamental analysis focuses on a company’s revenue, EBITDA, etc. This category mainly covers publicly available financial data. On the other hand, the qualitative fundamental analysis focuses on less tangible information about a company.
This category covers the quality of management, brand recall, intellectual property of the company, etc. The performance of the company largely depends on the people managing it. There are several parameters that can be considered to check the quality of the leadership team. Some people also look at the shareholding pattern of the company.
Most investors use a combination of both to arrive at the intrinsic value of the company.
While there are several advantages linked to fundamental analysis, there are some disadvantages too. Just like any other concept in finance and economics, an investor needs to be fully aware of the merits and demerits of fundamental analysis.
Merits of fundamental analysis
Let’s take a look at some of the benefits of fundamental analysis.
1. Helps in identifying good stocks
The main advantage of fundamental analysis is that it helps you in selecting a good stock after considering all the complexities of the stock market. Therefore, investors can select stocks of companies having solid business models and sustainable revenue projections. Fundamental analysis keeps you updated about the economy, interest rates, etc. Investors can select stocks after analyzing the companies from all angles. Thus, the probability of making profits is quite high in such an investment.
2. Provides a Strong Base for Investment
Fundamental analysis helps in providing a strong base. It can help an investor pick up the right stock from a bunch of stocks. An investor can check which stock (from the basket of stocks) will be benefited once all the related factors are considered. These factors include interest rates, GDP data, employment data, etc. After considering these, an investor can take a call accordingly.
3. Helps in developing a thorough understanding
Fundamental analysis helps an investor in the development of a rich understanding of the company’s business model. This understanding is of utmost importance since you are about to invest your hard-earned money. Since economic parameters are considered, investors are able to gather the right information to make rational decisions.
4. Helps in eliminating biases
Most investment decisions tend to go wrong as a result of cognitive biases. However, numbers don’t lie, and they limit the room for personal biases. This is critical for wealth creation over the long run. Instead of establishing entry and exit points, fundamental analysis helps an investor in taking a long-term view of the equity markets.
5. Helps in detecting red flags
With the help of fundamental research and analysis, it is easier to detect red flags in the financial statements of the company. These flags serve as a warning signal about possible problems with the company. In the long run, these red flags can impact the company’s performance and can restrict its ability to expand profit margins. Early identification prevents an investor’s wealth from being destroyed.
Demerits of fundamental analysis
After reviewing the benefits of fundamental analysis, let’s take a look at the drawbacks of fundamental analysis.
1. Time-consuming and complex
This is the biggest disadvantage of fundamental analysis. For conducting fundamental analysis, investors need to assess several areas and consider a range of possibilities using various assumptions. This entire process is complex and a bit time-consuming. Investors are required to closely monitor all the financial data related to the company and other economic parameters which can impact its performance.
2. Based on assumptions
When analyzing stocks using fundamental analysis, investors tend to make several assumptions and interpretations. These assumptions need skills, learning, knowledge, and experience. If there is any deviation from the expectations, investors can go wrong in their analysis and they might end up incurring losses.
3. Reliance on historical data
Stock analysis using fundamental analysis takes historical financial data into consideration to predict future earnings based on expected growth rates. Sometimes authenticity of this historical data can be questioned. Therefore, adequate checks are required before relying on historical data. Blindly relying on these numbers can prove to be dangerous.
4. Chances of misinterpretation are high
Fundamental analysis is conducted on the basis of reported and publicly available data. Therefore, investors should analyze the reported data and try to interpret it. The models in the fundamental analysis are complex and extremely sensitive. A minor change in the input value can result in a significant change in the final value. Therefore, the correct interpretation is extremely important.
Undoubtedly, fundamental analysis is a powerful tool and it can help investors decide whether or not the investment should be made. By adding technical analysis, investors can make an informative decision on whether the investment will be profit-making or not.
However, the fundamental analysis should always be applied with caution. This is because some of the information can be misleading. Skilled investors are able to filter out critical information and ignore false claims. Combining both merits and demerits of fundamental analysis, it’s safe to conclude that it is important to learn before investing.
Some methods involve forecasting the company’s revenues and profits based on assumptions. Therefore, it is of utmost importance to take realistic assumptions. That’s all for the article on Merits And Demerits Of Fundamental Analysis, We hope you enjoyed reading it. Happy Investing!
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