Fundamental Analysis
There is nothing more valuable than information. The right information used the right way at the right time can achieve incredible results, be it in sports, politics, war or investment. Information for investment purposes falls largely into two categories: fundamental analysis and technical analysis.
This is the ZF Markets guide to fundamental analysis. Use it to understand how information that is freely available can help you make better decisions on where to invest your money, as well as when to enter and exit a market.
What is fundamental analysis?
Analysts have long known that economic performance is cyclic in nature. Taken over an adequately broad period, the value of any individual commodity, share, market or economy follows a general up-and-down pattern. There are variations caused by myriad factors but certain trends emerge in the long-term.
Technical analysis attempts to decipher these patterns to predict when a rise or fall will occur. With the right technical analysis, you can correctly decide when to enter or exit a market.
The critical tool of technical analysis is a chart that tracks any price or value. It is distinguishable by its unique structure and colour.
The green parts indicate an increase in value while red segments signify a decrease. Each green or red section is made up of a thick line called the candle. The candle shows the range between the opening and closing price. Above and below each candle is a thinner line called the wick. The wick shows the range between the highest and lowest price for that period.
To a novice, a technical analysis chart can look simply like a virtually random series of movements. However, when paired with real-world information like time of day, week or year and current events, a pattern begins to emerge. Some of these patterns can be detected fairly easily while others are only uncovered by specialized computer programs.
It is not enough to extract a pattern from the chart. A valid hypothesis can only be formed after that theory of the rise and/or fall can be applied to many, if not all, previous price movements. To decide whether a theory is universally or widely applicable, we use a ‘back test’.
Back testing takes a proposed theory and tests it against actual data. For example, a trader may suggest that the price of the US dollar weakens against the Euro every Friday before the forex markets close. A back test will analyse the weekly USD/EUR figures as far back as possible and verify or discredit the hypothesis.
If a back test confirms a theory, a trading company may automate their trades based on the verified indicators. Using the above example, they may set up a schedule to buy USD on Friday and sell it for EUR before the following Friday.
Tools of fundamental analysis
From that introduction to fundamental analysis, you can see how complex it can be. However, calculating them on your own gives you an up-close insight into the interrelationships and develops your abilities as a trader.
Here are some of the chief factors you should consider when taking a “do it yourself” approach.
- Price-to-earnings ratio (P/E) – This is a ratio of the current sales price of the company as compared to the company’s per-stock share earnings.
- Price-to-sales ratio (P/S) – Also called sales multiple or revenue multiple, this is a comparison of the company’s stock price against its revenue totals.
- Projected earnings growth (PEG) – This is the growth rate of the company’s earnings over one year.
- Price-to-book ratio (P/B) – Also called the price-to-equity ratio, this is a comparison of a company’s book value to its stock value. The ‘book value’ of a company is its value (cost of assets less deprecation) as calculated in its financial sheets. P/B is obtained by dividing the latest stock closing price by the book value (from the previous quarter).
- Return on equity – Also called return on net worth, this figure is obtained by dividing the company’s net worth by the shareholder’s equity.
- Dividend pay-out ratio – A company may pay out some earnings from its net income to shareholders as dividends while retaining the rest to finance future company growth. This ratio compares how much has been paid out to how much has been retained.
- Dividend yield – This ratio is obtained by dividing the dividend paid out over a year per share to shareholders by the current value of the share. This percentage gives an idea of how much dividend investors can hope to gain for simply investing in the company.
- Earnings per share – This is calculated by dividing the net income, less dividends, by the number of outstanding shares. It gives investors an idea of how total profit relates to each stock share.
There is no doubt that this is a lot to take in, especially if you are a new investor. If you are overwhelmed by the sheer number of variables, the terminology and/or the calculations, ZF Markets can help.
Tips for fundamental analysis
Good, the reliable fundamental analysis takes time and considerable effort. While much of the information needed for fundamental analysis can be obtained fairly easily, finding the correlation between a financial factor and stock performance can be an elusive goal.
More often than not, no single piece of information can paint an accurate and comprehensive picture of a stock’s value. Virtually all the different pieces of information are interrelated or affected by each other. To gauge whether a stock is overvalued or undervalued, you have to understand these relationships.
To begin, make a list of all the factors to use in your fundamental analysis. They will fall into two (2) categories – macroeconomic and microeconomic – as we discussed earlier.
Within each of these two lists, categorize every factor by the level of direct impact you gauge them to have on stock value. This is an assessment replete with grey areas and your assumptions will affect the ultimate result.
Next, assess how each factor affects the other factors. For example, a booming economy will place upward pressure on a company’s earnings as more people have the cash to buy products that the business produces. Conversely, if the economic boom is occurring but slowing down, the effect on earnings will also decline.
What you should have at the end of your assessment is a web of relationships between every factor. This is just the starting point of your analysis before you trade.
Advantages and Disadvantages
The bulk of the opposition to fundamental analysis lies in its complex calculations and the imprecise manner in which factors are related. Assessments of factors are subjective and can vary significantly between analysts.
Also, as with any data, fundamental analysis cannot anticipate outliers and current events such as the COVID-19 pandemic. However, it also is largely ignorant of the cyclic nature of markets, which is the chief consideration in technical analysis.
The main advantage of fundamental analysis is that it gives a correlation between all the financial figures and the actual value of a stock or share. By taking the fundamentals that affect share price into consideration, you get a clear idea of whether a stock is overvalued or undervalued.
From that point, investing simply comes down to deciding whether you are comfortable with the magnitude of the difference between the actual value and potential value. Naturally, good assessments may place many companies in an intermediate grey area.
Remember, that does not mean that your analysis has been a waste – in fact, following the progress of these ‘grey stocks’ will allow you to identify important factors that you and even expert analysts may have overlooked.
Intelligent investing is all about using information correctly.