Fundamental analysis is one of two analysis methods that are useful when attempting to decipher markets. Whereas technical analysis attempts to understand securities through price history and volume movements, fundamental analysis aims to assess a security’s intrinsic value using external factors.
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.
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. Sometimes, when a company's share price is considered to be too high, the company will choose to perform a stock split, thus reducing the value of its shares and this makes them more affordable for investors.
A 'bottom-up' approach in fundamental analysis is perhaps the most common. Whereas top-down investing focuses on the greater economy and industry before analysis of a chosen company, a bottom-up approach focuses specifically on the stock and its fundamentals. This includes cash flows, growth potential and balance sheets, as well as financial ratios. Therefore, traders that carry out bottom-up fundamental analysis tend to assume that a company can perform well in a poorly-performing market.
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.
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.
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:
Fundamental analysis for commodities is based on either increasing or decreasing levels of supply and demand. Analysing the fundamentals of commodity market 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. Learn more about fundamental analysis in oil trading.
Quantitative fundamental analysis factors in commodity markets include market releases and reports for commodity markets. These reports can include:
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.
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.
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.
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. This makes it easier to perform company analysis when deciding whether or not to invest in a particular share. Several types of financial ratios can help determine a stock’s valuation, which are explained in more detail in the section below.
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.
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.
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.
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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.
Efficiency ratios measure how efficient a business is regarding its operations. Efficient companies can streamline business operations to improve their bottom line metrics.
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 a trading strategy 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.
Read more about the difference between technical analysis and fundamental analysis for more information on types of financial market analysis.
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