The basic difference between fundamental and technical Analysis is that, the emphasis on technical analysis is completely on the market price of a security, but the fundamental analysis deals with the intrinsic (real) value of the security. The inherent assumption in technical analysis is that the market price of a security reflects all publicly available information as theorised in the Efficient Market Hypothesis. The fundamental analysis rejects the Efficient Market Hypothesis. According to fundamental analysts the market does not always reflect the real value of securities and prices should not be used as a proxy for value. The fundamental analysis depends on the judgement of the intrinsic value of a security based on qualitative and quantitiavie methods. When the market price is lower than the intrinsic value (with some margin of safety) represents a buying opportunity whereas when the market price is lower than the intrinsic value represents a selling opportunity.
Note: Read to Technical Analysis, Part 1
DIFFERENT APPROACHES IN FUNDAMENTAL ANALYSIS
The primary question in Fundamental analysis is how to determine the intrinsic value of a company. The intrinsic value of a company depends on the future cash-flows and in-turn the earnings, but how exactly will you forecast the future earnings of a company? Analysts use two major approaches for this – Top- Down and Bottom-Up approach.
1. Top- Down Approach
The basic assumption in this approach is that a company performs well because of the external influences – macroeconomic, industry related factors. So, to understand which company (or companies) will perform well, we have to start from the global macroeconomic conditions, country specific macroeconomic conditions, which industries will perform well and invest in companies in those industries. The focus is on the economic and industry trends.
2. Bottom- Up approach
The basic assumption in this approach is that a company performs well because of the competitiveness of the company compared to its peers. This is what Warren Buffett calls a Competitive Moat – a differentiation so powerful which ensures higher profitability of a company for a long term. The competitive moat can be operational excellence which converts into lower costs, can be a brand or can a strategic positioning of the company in an industry.
The focus is on the specific company – so it is much more important to understand the business model of the company and the finances of the company to a great depth.
Although, these two approaches are presented as different approaches, they are often used in conjunction with each other. One can start with the top-down approach to understand the portable industry and then select the company to invest in using a bottom-up approach.
As the top-down approach focuses on the economic and industry trends which can short-term, the top-down analysis is associated with a short to medium term investments. The bottom-up approach is associated with a long-term buy and hold investments because it focuses on finding out company with sustainable competitive advantages.