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Fundamentals in Economics

[Harvard University - World Book]


- Overview 

In business and economics, fundamentals represent the main characteristics and financial data needed to determine the stability and health of an asset. This data can include macroeconomic or large-scale factors, as well as microeconomic or small-scale factors, to set the value of a security or business. 

Analysts and investors examine these fundamentals to estimate whether the underlying asset is considered a worthwhile investment and whether the market valuation is fair. For businesses, information such as profitability, revenue, assets, liabilities, and growth potential are considered fundamentals. Fundamental analysis allows you to calculate a company's financial ratios to determine the viability of an investment.

While fundamentals are often thought of as factors associated with a particular business or security, national economies and their currencies also have a set of fundamentals that can be analyzed. For example, interest rates, gross domestic product (GDP) growth, trade balance surplus/deficit, and inflation levels are some of the factors considered fundamental to the value of a country.


- Macroeconomic and Microeconomic Fundamentals

Macroeconomic fundamentals are topics that affect the economy as a whole and include statistics about unemployment, supply and demand, growth and inflation, as well as monetary or fiscal policy and international trade considerations. These categories can be applied to the analysis of the larger economy as a whole, or they can be related to individual business activities to change based on macroeconomic impacts. Large-scale macroeconomic fundamentals are also part of a top-down analysis of individual companies. 

Microeconomic fundamentals focus on the activity of a smaller part of the economy, such as a specific market or sector. This narrow focus can include issues of supply and demand within a particular market segment, labor, and consumer and firm theories. Consumer theory studies how people spend within specific budget constraints. The theory of the firm states that firms exist and make profit-making decisions.


- Business Base

By looking at the economics of a business, including overall management and financial statements, investors are looking at a company's fundamentals. These data points not only show the health of the business, but also the potential for further growth. A company with little debt and plenty of cash is considered to have strong fundamentals. 

Strong fundamentals indicate that a business has a viable framework or financial structure. Conversely, those with weak fundamentals may have issues with debt management, cost containment, or overall organizational management. Companies with strong fundamentals are more likely to survive adverse events such as recessions or depressions than companies with weaker fundamentals. Additionally, strength may indicate less risk if an investor is considering buying securities related to the aforementioned businesses.


Mount Fuji_Japan_062122A
[Mount Fuji, Japan]

- Fundamental Analysis

Investors and financial analysts are interested in evaluating a company's fundamentals to compare its economic performance relative to its peers, the broader market, or itself. Fundamental analysis involves delving into a company's financial statements to extract its profit and growth potential, relative risk, and ultimately determine whether its stock is over, under, or fair valued in the market.

Fundamental analysis usually involves calculating and analyzing ratios for like-for-like comparisons. Some common fundamental analysis ratios are listed below.

  • The debt-to-equity ratio (DE) measures how well a company finances its operations.
  • The quick ratio measures a company's ability to meet its short-term obligations.
  • Degree of financial leverage (DFL) measures the stability or volatility of earnings per share (EPS).
  • The price-to-earnings ratio (P/E) compares an investment to earnings in dollars. 
  • DuPont Analytics examines return on equity (ROE) by looking at asset utilization efficiency, operational efficiency, and financial leverage.

Fundamental analysis should be conducted using a holistic approach, utilizing multiple ratios, including bottom-up and top-down analysis, to draw specific conclusions and actions.



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