Fundamental analysis

Fundamental analysis is the most common way in which investors analyse securities.

It means exactly what it says: the valuation of securities on the basis of their fundamental financial characteristics. It therefore covers a broad range of techniques (including most of what is covered by this site). It is ultimately based on the scientific and testable theories of financial economics.

The most widely used alternative to fundamental analysis is technical analysis. Somewhat better founded alternatives include:

• complex quantitative models based on market data - these are used by hedge funds and index trackers
• pure trading strategies such as arbitraging - this is an essential part of the functioning of markets
• the use of behavioural finance to predict share prices - this is closest to technical analysis in spirit, has a better foundation, but remains rarely used.

The ultimately correct tools of fundamental analysis are very careful modelling and forecasting, and the use of theoretically correct valuation methods such CAPM based DCFs.

Given the difficulties of using methods that are absolutely theoretically correct, other techniques such as valuation ratios (such as PE) have their place.

At the heart of fundamental analysis are the models it uses for forecasting future profits and (most importantly) cash flows.

For more information on fundamental analysis see most of the rest of this site!