What Is fundamental analysis?
Fundamental analysis is perhaps one of the most common terms used in trading, and for a good reason. By definition, fundamental analysis is a method that evaluates the intrinsic value of a security, such as stocks and forex, or even cryptocurrencies, by looking at related economic and financial factors.
It involves studying anything that can affect the security’s value – from macroeconomics factors such as the state of the economy, industry conditions, and political situations to microeconomic factors like company-specific information and effectiveness of the company’s management.
Fundamental analysts use resources like financial statements, industry trends, economic reports, and market releases to calculate the intrinsic or “real” value of the security without factoring in market value or sentiments.
In a nutshell, intrinsic value, otherwise referred to as book value, is the sum of all the company’s assets minus its liabilities, while market value is the current price of the company’s stock.
By using fundamental analysis, traders and analysts extract a fair valuation of a company to determine if their shares are overvalued or undervalued and use this data to determine if they should invest in the shares now or wait for a better valuation in the future.
Fundamental Analysis vs Technical Analysis
In contrast to fundamental analysis that looks at factors like economic events and company information, technical analysis focuses on the price movement of the security in the market.
Technical analysis doesn’t look at a company’s financial statements on the premise that the stock price of a company already takes into consideration all the relevant information.
Instead, technical analysts use charts and other trading tools to look for trends and historical price patterns of the security, which are considered as the main deciding factors on whether or not to invest.
Another factor that sets fundamental analysis apart from technical analysis is their time horizon vis-a-vis the goals that the trader wants to achieve.
Fundamental analysis, in general, takes a long-term approach to trading while technical analysis is the exact opposite – it looks at short-term price fluctuations, hence it is often used by scalpers and day traders.
It has been said that while fundamental analysis and technical analysis exists independently of each other and caters to different kinds of traders, the two makes up for a more holistic and complete view of the market thus, it wouldn’t hurt to be familiar with both.
Fundamental Analysis of Stocks
Company stocks, also known as shares or equity, represents a claim of ownership on the assets and earnings of a company. They are issued primarily to raise capital as companies need money to finance and expand their business.
Once a company becomes publicly listed, their stocks can be traded in equity markets called stock markets, which can be in physical locations such as the New York Stock Exchange or over-the-counter (OTC) markets like NASDAQ.
Fundamental analysis makes use of publicly available data that are often released by these companies such as income statements, balance sheets, earnings reports, and cash flow statements to build an accurate assessment of how their business is doing and calculate their intrinsic value.
If a stock’s value is significantly higher than the stock’s current market price, this is generally considered a good investment opportunity and analysts may publish a buy or overweight rating for the stock.
On the other hand, a stock is considered overvalued if the calculated intrinsic value of a company is lower than the current market price. In this case, an underweight recommendation is issued by analysts, which will serve as a guide for interested investors.
Fundamental analysis revolves around the premise that behind every trend is a fundamental force that drives and fuels such market movement.
Using Fundamental Analysis to Pick Stocks
When using fundamental analysis, there are several financial ratios that you can use, so you can track a company’s performance to make comparative judgments with other companies and see if they are performing better or worse than industry average.
Financial ratios are computed using the numerical values taken from company reports and financial statements to gain meaningful information about a company.
The list below are just three financial ratios that you can use before you decide on investing on a stock:
- Price-to-Earnings Ratio (P/E Ratio) – a way to calculate how much you need to invest in order to receive one USD of that company’s earnings
- Return on Equity Ratio (ROE Ratio) – measures how effective a company is in relation to equity by showing how a company generates a profit compared to the money used as capital
- Profit Margin – is used to determine how profits are generated from sales revenue and show the degree to which a company makes money and how profitable it is
Overall, learning about fundamental analysis is crucial if you are looking at long-term investments and want to get the most out of your trades.