Fundamental analysis is a widely used method of stock valuation that is based on the performance of a company and the economic situation in the country or countries in which the company is based and/or trades. All of the large investment houses such as JPMorgan and Schroeders use this approach as it is very good for the determining long term value of a share.

The Approach

The most common approach to fundamental analysis is termed the "top down" approach and comes in three steps:

1.Analysis of the macroeconomic environment in all of the relevant markets.

Indicators that an investor may wish to consider include GDP growth, inflation, interest rates, exchange rates and productivity. First the investor must prioritise these and other indicators to decide which are likely to have the greatest impact on the financial performance of the company.

E.g. A firm based in the UK but whose main markets are overseas may find themselves adversely effected by the movements in the exchange rates. An investor must decide whether the company is prepared for these changes either by currency hedging or by sufficient diversification across different countries.

2.Secondly an investor should conduct industry analysis to gauge the relative health of the sector in which a firm is operating.

Factors such as growth in sales, price levels, competition (both domestic and foreign) and entry into and exit from the industry are among those that need to be considered.

Investors should note that just because an industry is unattractive it does not mean that there are no investment opportunities within the industry.

3.Finally the performance of the firm needs to be analysed carefully to decipher whether true value really exists in the firm's shares.

To do this an investor must look at the firm's published results and interpret them in the correct manner. Results should be compared year on year to decide whether the firm is improving in the long term. So, for example, has the company seen profits grow at a consistent rate or is performance particularly cyclical?

Other indicators include the debt-to-equity ratio, cash-flow, dividend payments, and all the commentary that is found in the statements which can give a good idea of the future direction of the firm. Industry comparisons are very useful tools in judging the potential of a firm to grow.

Aside from the financial information, a smart investor will try to dig a little deeper to discover whether a firm has a competitive advantage and also whether it is sustainable. To do this one must ask if the company has any core competencies that other firms in the industry do not posses such as superior managerial experience, exceptional reactionary abilities to changes in the market environment or high brand loyalty.

The Outcome

Based on the evidence gathered using the procedure above, an investor can have a good idea of the long term prospects of the company's share price. An investor will use something called "intrinsic value" upon which to base his/her decision.

Intrinsic value refers to what should be the "real" price of a firm's shares and so if the intrinsic value is above the current market price, this indicates that an investor should take a long position and vice versa if the intrinsic value is lower.

Fundamental analysis is primarily used to address the long term future share price of a company as it cannot account for short term volatility. To help predict the short term price movements of a particular share, investors may wish to use technical analysis instead.