Fundamental analysis: a beginner’s guide
Fundamental analysis is one of two analysis methods that are useful when attempting to decipher markets. Technical analysis attempts to understand securities through price history and volume movements. Fundamental analysis, however, aims to assess a security’s intrinsic value.
Continue reading to discover what fundamental analysis is and how it works. We look at how to use fundamental analysis in practice, covering assets classes such as forex, stocks, commodities and more.
What is fundamental analysis?
Fundamental analysis aims to uncover an asset’s intrinsic value or ‘real value’. This is a calculation of the value of the asset without factoring in market value or sentiment. Fundamental analysts use resources like financial statements, industry trends and market releases.
Once a trader has determined a security’s intrinsic value and considered other key indicators such as market sentiment, they can use that information to inform their investment decisions. When an investor has determined a stock may be under- or over-valued when measured by its fundamentals, this could be an indication to buy or sell.
How fundamental analysis works
Fundamental analysis aims to determine if you should buy or sell an asset by looking at public data. Fundamental analysts can identify buy and sell signals, work out an asset's intrinsic value and analyse macroeconomic trends that could impact an asset's valuation.
Depending on which asset class you analyse, several fundamental indicators may be suitable. Interest rates can influence bonds and currencies, while factors like competitive advantage and financial ratios can impact a stock’s value. These fundamental variables can segment into quantitative and qualitative fundamentals.
Quantitative fundamentals are any variables that are measured or expressed in numbers. These fundamentals are particularly useful as you can compare securities in the same asset class or industry. Some examples for stocks are P/E ratio, revenue and current liabilities. All these quantitative values exist in a company’s financial statements.
Qualitative fundamentals are anything that cannot be measured in numbers. These fundamentals can be a country’s media presence or a company’s board of directors. These factors can be driven by opinion and are harder to compare than quantitative fundamentals.
Using fundamental analysis
Fundamental analysis techniques vary depending on the type of asset class that is being analysed. For example, forex market analysis is undertaken from a ‘big picture’ perspective, which means that they look at valuation factors that encompass a whole country’s efforts. Conversely, stocks look at specific valuation metrics. Their valuation is often compared to market averages to help gauge its market positioning.
Please note that fundamental analysis is usually used for stocks, but can provide useful data for all asset classes. If you are not looking at charts, then you are most likely using fundamental analysis. Fundamental analysis encompasses anything from the broad economic outlook to specific valuation metrics.
Fundamental analysis of forex
When analysing the forex market, fundamental analysts review the economic, political and social trends that could influence the supply and demand of their chosen currencies. Drawing a relationship between a variable and a currency’s value is the relatively easy part. However, analysing and understanding all the factors that make up the value of a currency pair can be a lot more complex.
The aim of fundamental analyst in forex trading is to determine if the economy is growing or shrinking. Deciphering this could expose if the currency value is set to increase or decrease. However, as forex currencies exist in pairs, analysts need to take into account one currency’s value relative to another’s value.
Key economic indicators analysed when measuring the value of forex currencies include:
- Gross domestic product
- Inflation rates
- Interest rates
Fundamental analysis of stocks
By using a company’s balance sheet, income statement and cash flow statement investors can begin to draw a picture of a stock’s value. Fundamental analysts use stock analysis data to understand where that business is positioned in the industry, the economy and relative to competitors.
Several types of financial ratios can help determine a stock’s valuation. These include:
Price ratios
Price ratios help to understand if a stock’s market price is suitable with relation to its fundamentals, but more specifically, if the stock’s valuation is justified. This can be discovered when compared to the industry average and direct competitors.
- EPS (earnings per share). A company’s profit divided by the number of available shares. Companies with higher EPS are more profitable.
- P/E (price-earnings) ratio. A key valuation ratio that compares EPS to a company’s share price. A high P/E ratio could suggest that a stock is over-valued, whereas, a low P/E ratio could suggest a stock is undervalued or an unattractive investment. A company’s P/E ratio is a more complete measure than its EPS.
- PEG (price-earnings-growth) ratio. A company’s P/E ratio divided by the annual earnings growth rate per share. The PEG ratio builds upon its P/E ratio but considers a company’s growth. A PEG ratio of over 1.0 suggests overvaluation. Nevertheless, traders should remember to compare against the industry average.
- P/B (price-book) ratio. Compares a company’s current price on the market to its book value. Any stock under 3.0 is a reasonable valuation, while ratios closer to 1.0 suggest that it may be an undervalued stock.
Profitability / ROI (return on investment) ratios
Profitability ratios gain insight into a company’s efficiency at generating profits from business operations. Having a higher profitability ratio in comparison to competitors is a competitive advantage. These ratios provide useful information when compared against a company’s history, its immediate competitors and industry averages.
- ROA (return on assets). Gives a quick insight into how efficient a company is in transforming assets into income. Calculated by dividing total income by total assets.
- ROE (return on equity). Measures how efficient a company is in returning income to its shareholders. Calculated by dividing total income by total shareholder equity.
- Profit margin. Profit margin measures the efficiency of how a business can turn sales into profits. To calculate the profit margin divide net income by net sales.
Liquidity ratios
Liquidity ratios form a class of metrics to measure a company's liquidity, that is, how able a company is to pay its short-term debts without raising capital. Companies with low ratios should raise concern. As they do not have a cash buffer, any market turbulence could cause impose serious issues.
- Current ratio. The current ratio is calculated using the balance sheet. Its formula is current assets divided by current liabilities. A company with a ratio below 1.0 can be a risky investment prospect. Businesses are stronger when their current assets exceed current liabilities.
- Quick ratio. Calculate the quick ratio by taking the difference between current assets and inventory. Then, divide this figure by current liabilities. The quick ratio is similar to the current ratio but removes a company’s inventory from current assets. This is because the liquidation of a company's inventory could take months to sell.
Leverage ratios
Leverage ratios are also known as gearing ratios or debt ratios. They aim to uncover how much debt funds a company’s operation. Generally, the lower a gearing ratio, the less a company relies on borrowing as part of its operations. However, it is worth noting that companies with low gearing ratios may not take the same growth opportunities as highly geared firms do.
- D/E (debt-equity) ratio. Calculated by taking total liabilities over a company’s total equity. A company with a high D/E ratio compared to its peers can be viewed as a high-risk investment.
- Interest coverage ratio. Measures how many times a company can make interest payments on its debt with its earnings before interest and taxes (EBIT). This provides a short-term view of a company’s financial health.
Efficiency ratios
Efficiency ratios measure how efficient a business is regarding its operations. Efficient companies can streamline business operations to improve their bottom line metrics.
- Asset turnover. Similar to ROA, asset turnover shows how efficient businesses are at generating sales from their assets. Calculated by taking a company's total sales and divide by its total assets.
- Inventory turnover. This measures how many times a company has sold and replaced its inventory. This can differ between industries, but generally the higher a company’s inventory turnover the better. Calculate by taking COGS (cost of goods sold) and dividing it by average inventory.
Discover more stock valuation methods in our article on analysing a company’s fundamentals.
Fundamental analysis of cryptocurrencies
Most traders use technical analysis to trade cryptocurrencies. However, you should not ignore the fundamental values that can impact cryptocurrency’s supply and demand. Like other assets, it is possible to apply fundamental analysis strategies to cryptocurrency markets.
Variables such as legitimacy, regulation and security can affect the supply and demand of cryptos. Even if these variables do not change, news surrounding these areas can affect market sentiment, cryptocurrency adoption and trading volume. As the bitcoin market is newer than most conventional markets, it is not trusted by many institutions and members of the public. Therefore, it is particularly sensitive to any shifts in market sentiment.
Fundamental analysis of commodities
Fundamental analysis for commodities is based on either increasing or decreasing levels of supply and demand. Analysing the fundamentals of commodity markets can provide insight into the intrinsic value of a commodity, and traders can attempt to forecast its value in the future.
However, certain commodities such as oil tend to impact other asset classes more than any other single financial instrument. Oil can have a huge impact on the global stock markets and forex pairs. This is because demand can be dictated by a nation’s economy, politics or changing industries. While supply variables can be affected by a country’s international relations and oil production.
Quantitative fundamental analysis factors in commodity markets include market releases and reports for commodity markets. These reports can include:
- WASDA (World Agricultural Supply and Demand Estimates)
- COT (Commitments of Traders)
Both of these reports provide quantitative data, which traders can use to forecast and understand a commodity market’s fundamentals.
Qualitative measures are harder to evaluate and tend to be more complex when compared to quantitative measures. Anything from trade agreements, trade wars, industry regulations and the weather forecast can impact the supply and demand of commodities.
Fundamental analysis of indices
When using fundamental analysis, stock indices are treated in a similar way to shares. This is because stock indices are a collection of shares, and share similar financial ratios. However, they are not the same as stocks. Stocks can be compared to market indices to provide a ‘big picture’ context, whereas, you can only compare indices to other indices.
For a big picture context, it is best to compare the market index to the MSCI World market index. This index covers the top 1,644 company’s stocks weighted by market cap throughout the world.
Fundamental analysis of bonds
There are two main bond markets:
- Government bonds which are also known as gilts in the UK
- Corporate bonds
Gilt prices fluctuate mostly due to interest rates changes, the country’s credit rating and economic policy updates. Unlike stocks, you can measure gilts with interest rates as a primary indicator.
The same goes for corporate bonds, as you must take into account the company's credit rating. A bond's credit rating is the ability of the business to pay back the bond. This means that a company’s financial health plays a big part in the value of a corporate bond.
Summary
You can apply fundamental analysis techniques across all markets. They are most prevalent when analysing the stock market or foreign exchange market. Companies listed on major stock exchanges must release their financial data on an annual basis. This provides analysts with a wealth of data to determine the intrinsic value of stocks.
Commodity and foreign exchange markets act in a similar but less-granular manner. Each nation releases key financial information that can affect financial markets, including the commodity and forex markets.
Using fundamental analysis can provide a great set of tools for market insight, but each indicator should not be looked at in solitary. Fundamental analysis factors cannot provide buy or sell signals by themselves. They should exist as part of an analysis that covers many variables.
Fundamental analysis variables provide a means by which you can measure countries, stocks and other assets. Once individual markets are put onto a scale, investors can start to work out their intrinsic value in relation to one another.
See the difference between technical analysis and fundamental analysis for more information on types of financial market analysis.
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