Fundamental analysis

What is fundamental analysis?

Fundamental analysis is one of the two main methodologies that traders use to carry out market analysis, the other being technical analysis . Whereas technical analysts study historical price action, trading volumes and other market data to try to predict future price movements and establish market entry and exit points, fundamental analysts believe that an asset’s market price doesn’t necessarily reflect its true value. Instead, they start by studying macroeconomic data (a top-down approach) or – in the case of share trading – a company’s earnings reports (a bottom-up approach) to build a picture of what an asset is really worth.

If a trader applying fundamental analysis techniques finds that an asset is worth more than its market price, he or she would deem the asset to be undervalued by the market. Then the trader might buy the asset in the expectation that the market will soon realise its ‘mistake’, sending the asset’s price higher to reflect its true worth.

Likewise, if the asset’s fundamentals indicate that it may be worth less than its market price, it could be deemed overvalued. The trader might then sell or ‘go short on’ the asset in the expectation that its price will fall to reflect its real value.

Top-down vs bottom-up fundamental analysis

There are two basic approaches to fundamental analysis: top-down analysis and bottom-up analysis.

Top-down analysis starts with a broad, big-picture view of the world economy, taking into account global and national economic indicators such as GDP, inflation and interest rates, before drilling down into a specific region, country and market. Only then do top-down fundamental analysts focus on a target financial instrument – be it a company stock, currency pair or other asset.

Conversely, bottom-up analysis starts with a specific company, currency pair or other instrument, then broadens out to consider the wider industry or region, and other high-level factors that may impact its price.

Fundamental analysis by asset type

The tools that traders use for fundamental analysis vary by asset class. For example, share traders might choose to look at key data points in a company’s earnings report, such as revenue, earnings per share (EPS), profit margin, cash flow, and projected growth. Meanwhile, forex traders may analyse a country’s inflation data to examine the implications for its currency, or they might study central banks’ interest rate decisions and meeting minutes, which can offer insights into a country’s economy and the path that rates might take in the future.

Quantitative and qualitative data

Whatever their preferred asset class, fundamental analysts may use quantitative data, qualitative data or a blend of the two in their research.

Quantitative fundamentals are variables that are measured or expressed in numbers, making them useful for comparing one instrument to another in the same asset class. In the case of stocks, quantitative fundamental analysis could draw on financial statements, balance sheets, and data points such as revenue, net profit, current liabilities, and the P/E ratio – the latter being a key fundamental valuation ratio that divides a company’s share price by its EPS. A high P/E ratio can suggest that a stock’s price is high relative to earnings and may be overvalued, while a low P/E ratio could indicate that a stock price is low relative to earnings and may be undervalued.

Qualitative fundamentals are variables that cannot be easily represented by numbers but which may nevertheless have a bearing on the value of an asset, such as the personality of a company’s CEO or media coverage of one of its products. These factors can be driven by subjective opinions, making asset-to-asset comparisons somewhat difficult.

Pros and cons of fundamental analysis

Pros

• Fundamental analysis can help traders make informed trading decisions.

• By basing your trading decisions on information you’ve gathered and analysed, you may reduce the role that personal biases, instincts and emotions can play in trading.

• Fundamental analysis can help you identify companies that have been undervalued or overvalued by the market.

Cons

• Fundamental analysis looks at the big picture, making it well suited to long-term investing, but it may be of less use when trading on short-term price swings.

• Traders looking to create a research methodology for holding positions over the short term might find technical analysis more useful.

• Because it takes a broad view of the market, fundamental analysis can be complicated and time-consuming; individual traders may lack the resources to carry out meaningful fundamental research and act on their findings in a timely fashion.

• Financial statements, balance sheets and cash flows can be manipulated, possibly prompting a trader to place trades based on false or misleading information.

• While fundamental analysis can provide a full and clear view of the market, there is still a chance that an unexpected economic event could catch traders and investors by surprise, upending your carefully researched trading thesis or investment case.

Conclusion

Fundamental analysis is a way to gauge what an asset is really worth. It can help traders to discover assets that are trading at prices above or below their true value. An alternative research methodology is technical analysis, which focuses on analysing historical data to make predictions about future price action. However, fundamental and technical analysis are not mutually exclusive. For example, many traders use fundamental analysis to narrow down a selection of assets to a few promising candidates, while also using technical analysis techniques to establish entry and exit points for their trades, or to set stop-loss orders as part of their risk-management strategy. Ultimately, it is up to the individual trader to do their research, experiment with different methodologies, and find an analytical approach that works for them.

How to conduct fundamental analysis

• Open an account with us

• Analyse financial data and keep up to date with economic news using our in-platform Morningstar reports and Reuters news feed.

• Practise trading in your free, no-risk demo account. Then, when you’re ready, step up to a live account.

CMC Markets is an execution-only service provider. The material (whether or not it states any opinions) is for general information purposes only, and does not take into account your personal circumstances or objectives. Nothing in this material is (or should be considered to be) financial, investment or other advice on which reliance should be placed. No opinion given in the material constitutes a recommendation by CMC Markets or the author that any particular investment, security, transaction or investment strategy is suitable for any specific person. The material has not been prepared in accordance with legal requirements designed to promote the independence of investment research. Although we are not specifically prevented from dealing before providing this material, we do not seek to take advantage of the material prior to its dissemination.