What is Investment Analysis and Why is it Important?

Money does not grow on trees; however, it does grow if you save and invest wisely. Understanding how to invest effectively for your financial health is an essential life skill. No matter how much or how little you have, it is crucial to educate yourself about the financial opportunities available to you and to deploy your money in the right investment avenues. No one can guarantee that you will generate profits from the investments you make. But, if you conduct strong fundamental and technical investment analysis and follow through with a wise plan, you can get one step closer to gaining financial security over the years and can reap the multiple benefits of managing your money well.

The right investments make your money work for you. Hence, most financial experts recommend that you learn before you invest. Your decision to invest is your first step on the road to financial security. Additionally, if you want to make the most of this journey, it is always advisable to make an informed decision after an in-depth investment analysis.

Typically, investment analysis is a broad term for different methods of analyzing a potential investment opportunity, industry sector, and economic trend. The objective of conducting an investment analysis is to evaluate the performance of an investment and its suitability for your financial portfolio. Strategic investment analysis allows you to determine the right entry price point for the concerned investment, the expected period for holding the investment, and the role of the investment in your comprehensive financial portfolio.

There are different approaches to investment analysis, including assessing past returns to examine future performance, selecting an investment based on its risk level, value, yield potential, volatility, etc. Investment analysis is also known as security analysis or financial analysis. If you understand the investment, you are less likely to make an expensive mistake. It is the key to building a strong portfolio. If you wish to know about investment analysis in detail, how you can analyze investments and their potential risk level, value, feasibility and more, consult with a professional financial advisor who can guide you on the same.

Here is an overview of investment analysis and why it is important:

What is investment analysis?

Investment analysis is a comprehensive term that refers to a variety of calculations and assessments to determine the feasibility of an investment opportunity. It involves using different metrics such as assessing past returns, yield potential, price movement, risk, and more to make better financial decisions. A sound investment analysis helps you understand how a specific investment is likely to perform in the future and how suitable it is for your financial portfolio. Strategic investment analysis can also involve evaluating the feasibility of an individual investment strategy, such as its applicability in its current times, needs of the investor, portfolio performance over time, and need for a correction or adjustment.

For instance, when investing in a mutual fund scheme, the investment analysis will involve assessing how the fund performed in the past compared to its index benchmark. It will also evaluate the mutual fund portfolio relative to its peers based on factors, such as performance, expense ratio, fund manager experience, portfolio composition and diversification, investment style, management stability, and more.

The investment analysis process helps you determine the best investment per your unique financial requirements, such as goals, risk tolerance, period, and return expectations.

What are the different approaches to investment analysis?

Investment analysis is a broad term with different methods to assess securities, sectors, markets, and more. On an expansive level, investment analysis can be divided into these approaches:

1. Top-Down approach 

Atop-down investment analysis begins by analyzing the broad economy, market, or industry trend. The objective of the approach is to shortlist investment opportunities that will likely benefit from the macroeconomic trends. The idea is to look at the broad picture and narrow it down to find the most suitable investment. Top-down is one of the most commonly used approaches to investment analysis. It studies macroeconomic factors, such as GDP, employment, taxation, interest rates, currency movements, inflation, etc.

For instance, an investor studied different industries and concluded that the technology industry outperformed the healthcare sector. Consequently, the investor may allocate a larger share of their portfolio in the technology industry than healthcare. The investor then seeks out the best-performing companies in the technology sector.

The top-down analysis aims to allocate investments in economic regions that outperform rather than placing bets on specific companies. For instance, if the growth in the Asian market is better than the domestic growth in the United States, it could be beneficial for an investor to allocate more funds in securities, such as ETFs (Exchange Traded Funds) that follow particular Asian countries. From this point, the investor can fund specific companies for investment by assessing their fundamentals.

The top-down approach saves time by assessing large-scale economic aggregates before investing in specific regions or sectors and then particular companies. However, this approach to investment analysis might cause you to miss out on specific companies that outperform the broader market.

2. Bottom-up approach

The bottom-up investment analysis process focuses on assessing individual securities and reducing the apparent importance of macroeconomic factors and market cycles. In this approach, you primarily analyze a specific company’s fundamentals, such as its earnings, and assess its performance relative to the industry or the overall economy. The bottom-up approach assumes that some companies can even perform well in a relatively underperforming industry. For instance, using the bottom-up approach, an investor can find that a manufacturing company makes for a compelling investment and allocates a large sum to it despite the negative industry outlook. Through the bottom-up approach, the investor concludes that the stock can likely outperform its industry.

Alternatively, the bottom-up tactic can also indicate issues in a company, even if it’s a part of a booming industry.

The strategy uses microeconomic factors, such as the company’s financial statements, products, and services, supply and demand, etc. For instance, a bottom-up approach might suggest investing in a particular company because of the company’s unique market strategy, business structure, products, etc. The bottom-up approach begins at the individual firm level and then moves up to the industry group, economic sector, market, and macroeconomic factors.

3. Fundamental analysis

Fundamental analysis is an investment analysis process that helps assess the intrinsic value of a security by analyzing its economic and financial aspects. This investment analysis approach can involve studying macroeconomic factors like industry outlook, interest rates, etc., to microeconomic factors like the stability of the company management, revenue, future growth, return on equity, profit margins, etc. Some financial metrics used for fundamental investment analysis include Price-Earnings (P/E), Earnings per Share, Book value, ROE, Dividend Yield, Debt to Equity, and other current ratios. The analysis also includes an assessment of the company management and competitive advantage of the business.

The objective is to compare the security’s intrinsic value derived from the fundamental analysis with its current price to determine if the particular security is overvalued or undervalued. If the fair market value (obtained through the fundamental analysis) is less than the market price, the security is undervalued and can be invested in. Alternatively, if the fair market value is lower than the current market price, the security is overvalued, and a sell or no action recommendation is recommended. All information required for fundamental analysis is available in company reports, such as 10-K, 10-Q, etc., submitted to the Securities and Exchange Commission.

The simple way to do fundamental analysis is to map an investment with its performance and fundamental metrics with a benchmark, such as the S&P 500. If fundamental metrics like ROA (Return on Assets) and ROIC (Return on Invested Capital) are better than the mapped benchmark, the company can prove to be a sound investment.

4. Technical analysis

Technical analysis is an investment analysis approach that aims to evaluate investments and identify trading opportunities by assessing the statistical trends of the trading activity, such as price movement and trading volume. This investment analysis and portfolio management strategy assumes that the past volume trading and price movements can be a valuable indicator for the future price movements of the security. For instance, assume the average price of a share over 50 days exceeds its moving average of 200 days. According to the technical analysis, this condition indicates a potentially profitable buying opportunity. However, if the 50-day stock price of the stock falls below its 200-day moving average, technical analysis would conclude it as an opportunity to sell to avoid future losses.

Technical analysis works in contrast to fundamental analysis that focuses on the financial soundness of the company instead of relying on its historical price patterns or trading volume trends. This investment analysis approach can be used for stocks, fixed-income securities, commodities, futures, currencies, and other securities.

Technical analysis in investment is mostly used to obtain short-term trading signals with the help of various charting tools that essentially assess how supply and demand for a security impacts its price, volume, and overall market volatility. This analysis is often used in conjunction with other approaches to investment analysis.

Why is investment analysis important?

Investment analysis is essential because it helps you make informed investment decisions that can minimize the risk of loss and increase your return potential. The relevance of using investment analysis is better understood through a real-world example of investment analysis.

Here is an example of the initial investment analysis of a foreign stock. Albemarle & Bond Holdings, a British company that operated pawn shops, was listed on the London Stock Exchange. The company’s stock price was highly undervalued. It was priced at only 20% of its Net Current Asset Value (NCAV), 80% lower than its intrinsic value. The company has adequate past earnings; its past price was above NCAV; the company had existing operations, but it ranked low on the debt to equity ratio. Albemarle & Bond Holdings had a debt-to-equity ratio of 70%, signaling a high debt amount. Ideally, per the fundamental investment analysis, firms should have a no or low debt (a debt to equity ratio less than 25%). On further assessment, it was found that the company had a low current ratio and barely any cash on hand. The NCAV was falling steeply.

As per the investment analysis, the stock of Albemarle & Bond Holdings was not a sound investment. Soon after the analysis, in 2014, the company filed for bankruptcy, causing massive losses to investors.

Investors who used corporate investment analysis techniques did not invest in the stock and could avoid a huge potential loss. However, investors who invested in the stock solely on its price and without conducting a comprehensive investment analysis suffered significant losses when the company declared bankruptcy.

That said, it is not mandatory to use only one investment analysis process, you can use multiple investment analysis approaches to arrive at the right decision. In some situations, technical analysis is a better fit than fundamental analysis. Moreover, in specific securities like foreign stocks, it may be advisable to first use the top-down investment analysis approach and then rely on both fundamental and technical analysis to find the best stocks for your investment.

To conclude

Investment analysis is vital when assessing an individual investment opportunity. Without the optimum investment analysis and portfolio management, you could be picking up random securities per media hype, speculation, peer recommendation, etc. Using these different approaches to investment analysis can help you make a better and more educated decision, likely leading towards a profitable portfolio. Selecting the wrong investment avenue could consume your entire investment corpus or more. However, if selected wisely with the right investment analysis, you can realize high gains.

You can use any investment analysis process to identify a potentially viable investment opportunity. The more information and data you use, the better and more accurate evaluation results you can generate. If you think investment analysis is complicated or you do not have the time to put in the required effort, it is best to consult a professional financial advisor who has the expertise, knowledge, and tools to use an appropriate investment analysis process and create a portfolio that fits your expectations.

If you are looking for guidance on how to identify potential investment opportunities suited to your financial needs and goals, use WiserAdvisor’s free advisor match service to find highly qualified and vetted fiduciary advisors who can do the same for you. Answer a few questions about yourself and get matched with 1-3 fiduciary advisors that are suited to meet your financial requirements.