Fundamental analysis is an attempt to evaluate the underlying value of the asset or security you are trading - and deciding whether the current price under - or overvalues it.
How does fundamental analysis work?
If the fundamental analyst decides the market undervalues a certain asset, they would look to buy it.
However if the asset is thought to be overvalued, the analyst would look to sell it. For analysing stocks, a trader will look at things like a company’s balance sheet and the health of the industry the company operates in.
A forex trader using fundamental analysis will evaluate economic data like GDP or central bank decisions to determine likely moves in the currency. For commodities trading, a trader will look at the factors that drive the supply and demand for the commodity like the weather or changes in industrial usage.
Different types of fundamental analysis
Each asset class has its own niche form of fundamental analysis, which tends to mean fundamental analysts need to specialise. Simply looking at the raw data is not enough to determine an asset’s intrinsic value. In the case of the stock market, Investors tend to measure the valuation of a stock using financial ratios like the P/E ratio. P/E stands for price to earnings and is measured by dividing the share price by annual earnings. A high P/E ratio means a company is highly valued whereas a low P/E ratio means the company has a low valuation.
Value investors will buy under-valued stocks and wait for the market to fully value them with a higher stock price. Forex traders must compare economic data with previous datapoints to determine if the data is improving or deteriorating. And more importantly, compare the actual data to consensus forecasts to determine whether the data beat or missed expectations. Breaking news, geopolitics, and environmental disaster can all affect an exchange rate too.
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