The aim of fundamental analysis is to try to ascertain whether the asset is under or overvalued from an investors point of view.
Whilst technical analysis focuses solely on price action, fundamental analysis looks at the intrinsic value of an asset.
Fundamental analysis is common in stock trading but it can also be used to gauge the price of any asset from currencies to indices to commodities to bonds.
A fundamental analyst will examine and scrutinize any factor which could impact on a security’s value. These could be macro-economic factors which look at the performance of the economy as a whole. Or micro economic factors, which consider financial conditions and decisions, and corporate governance.
How Fundamental analysis works
The aim of fundamental analysis is to determine the intrinsic value of a security to decide whether the market is currently under or over pricing it. You would then look to buy at a discount before the market then catches up. Or go short at a premium before the rest of the market realises
Fundamental analysis for forex and indices
This a way of looking at the forex and index markets through economic, social or political factors.
The basic idea being that the better a country’s economy is performing the more foreign investors and businesses will invest in that country. To obtain assets these businesses and investors require that country’s currency. Furthermore, when an economy is doing well, the central bank is more likely to raise interest rates to prevent the economy from overheating. Interest rates are key to understanding exchange rate movements. When a country has higher interest rates relative to others, investors look to move their money there to benefit from the higher yields. This boosts demand for the currency, lifting its price.
For this reason, forex traders who carry out fundamental analysis will focus on GDP data, employment figures, inflation numbers and central bank policy. Fundamental traders will often use an economic calendar to identify when these important data releases are each month.
Indices can also be moved by the same high impacting economic data, but possibly for different reasons to what you might expect.
For example, if the BoE moves to lower interest rates, this would most likely pull the pound lower, which can actually boost the FTSE. This is because the FTSE is compiled of over 70% of multinationals which earn abroad and so benefit from the preferential exchange rate when the pound falls. Another example could the Dax. When the euro weakens, the Dax which is dominated by exporter firms tends to rally. From these examples you can see the that the fundamentals which move the particular market could be very different.
Fundamental analysis for stocks
Fundamental analysis when trading stocks looks at the company at the most basic financial level. Traders that adopt fundamental analysis on a stock are looking to assess the financial health of a company to determine whether it is over or under valued. At its heart, when trying to understand the health of a company it is fundamental analysis cashflow. If cashflows cover expenses, the company is in a stable position. This type of analysis could involve examining key ratios of a business. Fundamental analysis of stocks often takes several factors into account such as revenue, production, asset management and borrowing costs in the form of interest rates. The goal being to determine the worth of the stock.
Warren Buffet is famous for successfully implementing fundamental analysis to pick stocks that made him a billionaire. Fundamental analysis can help uncover companies with strong balance sheets, valuable assets, stable earnings and the ability to weather difficult times, in other words companies that have staying power.
Fundamental Analysis Earnings
Earnings are key. This is the bottom line as far as investors are concerned. How much money is the company currently making and how much is it expecting to earn going forwards? Companies report earnings quarterly. When a company is earning well and indicates that it will continue making solid profits, this generally leads to higher an increase in the stock price and higher dividends. Some earnings investors focus squarely on earnings season, buying stocks before quarterly earnings reports.
On the other hand, when earnings fail to hit market expectations or a company provides the market with a disappointing forward guidance, a stock can often get hammered.
Whilst earnings are extremely important, they don’t give an indication of how the market values a stock. This is something that you can work out using fundamental analysis to calculate certain ratios. The ratios that are useful can be complicated to calculate, but don’t let this put you off. There are many resources on the internet which can help with these.
Some of the most popular fundamental analysis tools include:
Earnings per sharePrice/Earnings ratioProjected earnings growthPrice to book ratioDividend payout ratio Dividend yield
Fundamental analysis for commodities
Commodity markets can be easier to understand for fundamental analysis pros and beginners because they are affected by more obvious contributing factors. This makes fundamental analysis on commodities easier to grasp.
For example, oil is affected by supply and demand factors. Any supply restrictions such as sanctions or output limits could limit supply boosting the price. Increased demand owing to a stronger global economy could also boost demand and therefore the price.
Benefit of Fundamental analysis
Fundamental analysis is more suitable for the medium to longer term trader. A swing trader could carry out fundamental analysis, as could a trend trader. This type of analysis is not often suitable for very short-term traders. The ability to identify longer term trends can benefit patient traders.
One of the less obvious advantages of fundamental analysis is that you develop a deep understanding of the business or the market. After so much painstaking research a fundamental analyst will be familiar with key revenue and profit drivers behind a company. As we have already mentioned, earnings and earning expectations can be a strong driver of equity prices.
Problems with fundamental analysis
The principal disadvantage of fundamental analysis is that it can be time consuming. A fundamental analyst must be strict with where to draw the line with the analysis, otherwise it it has the potential to go on almost indefinitely.
Furthermore, there is not a one size fits all model with fundamental analysis. Different sectors must be analysed in different ways and this puts pressure on resources and time. For example, looking at the number of subscribers for Netflix is not a model that can be transferred onto Rio Tinto. Oftentimes it is the qualitative fundamental analysis combined with the quantitative that yields the most accurate results.
There is always the risk that the market has already priced the information in. However, if the fundamental analyst believes differently then they cold end up always trailing the intrinsic value of the stocks rather than getting ahead of it.
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