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What is financial analysis?

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Last updated a month ago

What is financial analysis?

The three most common types of analysis undertaken by investors to estimate the risk and expected return of stocks are fundamental, technical and quantitative analysis.

Financial analysis is the process of analysing and evaluating companies, their projects, management and financial statements alongside trends within the market to determine their performance. Investors will undertake some form of financial analysis before making investment decisions.

The three most common types of financial analysis are fundamental, technical and quantitative. These three types of analyses are the most common methods investors use to weigh risk against future return and are all unique. 

Fundamental Analysis 

Fundamental analysis focuses on evaluating the intrinsic value of a company and how it could change in the future. Financial statements, industry trends and external factors are all taken into account to evaluate the company. The two main categories of fundamental analysis are top-down and bottom-up analysis.

Top-down analysis

Top-down analysis refers to taking a broader look at industry trends and the market as a whole before narrowing down to the sector, industry and finally the company.

An example of top-down analysis would be to look at the larger macro factors such as GDP and inflation before analysing a sector, e.g. lithium. Taking these factors into consideration, the next step would be comparing individual companies within the sector to look into their performance metrics. 

Bottom-up analysis

Bottom-up analysis is the opposite, starting at the bottom at a company level before considering the larger market factors. 

An example of bottom-up analysis is to begin by looking at a company's organisational structure, financial statements and other financial indicators before comparing the company to competitors within the sector and then finally looking at the larger macro factors such as GDP, interest rates and inflation.

Technical Analysis

Technical analysis uses historical data to look at supply and demand and its effect on price, volatility and overall value. Typically, charting tools are used to forecast future trends under the assumption that historical data is a good way of predicting the future movement of the stock price. 

Technical analysis will involve using some of the following indicators such as:

  • Price chart patterns 

  • Implied volatility 

  • Moving averages 

  • Trading volume 

The effectiveness of technical analysis has long been a topic of debate within the efficient-market hypothesis which suggests that market prices are unpredictable. This directly contests both technical and fundamental analyses as they claim to predict prices.

An example of technical analysis would be to analyse a chart of a company you’re interested in. An investor could then pick which indicators they believe are the most important, identifying trends and implementing charting strategies to forecast future movements in the share price.

Quantitative Analysis

Quantitative analysis is more aligned with technical analysis than fundamental analysis, using mathematical and statistical methods to estimate the value of a stock. Quantitative analysis can refer to a variety of methods such as derivatives pricing, risk management, statistical arbitrage, algorithmic trading and electronic trading.

This type of analysis is typically used by larger firms and can involve high frequency trading. Algorithmic models that have been developed over long periods of time usually predict opportune entry and exit points, as well as the risk and expected return of the stock.

An example of quantitative analysis would be an algorithm built to predict future share prices by reading indicators built into the computer model such as implied volatility. The algorithm could then calculate the preferred portfolio balance and execute trades to rebalance the portfolio.

DISCLAIMER

This does not constitute an offer to sell, a solicitation of an offer to buy, or a recommendation of any security or any other product or service by Fresh Equities Pty Ltd, its representatives or any other third party regardless of whether such security, product or service is referenced.

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