Fundamental analysis uses publicly available information about an asset to judge its intrinsic value. When done correctly, fundamental analysis can provide you with a thorough understanding of an asset’s strengths and weaknesses.
What is fundamental analysis?
Fundamental analysis is a method of evaluating securities to determine their intrinsic value. It considers the financial situation of a company or other asset and the overall health of the market it trades in using key economic data.
The information you might use for fundamental analysis ranges from the minutia of how a company’s finances are managed to how global events impact levels of supply and demand. Unlike technical analysis, fundamental analysis does not consider trader sentiment or current market value. Instead, it seeks to identify an asset’s fair value despite its current trading conditions.
How does fundamental analysis work?
Fundamental analysis works by calculating the intrinsic value of an asset using economic data from multiple sources to build a holistic picture of a security’s strengths and weaknesses. The purpose of using fundamental analysis in trading is ultimately to determine whether an asset is over or undervalued and whether a correction in price could occur.
The value of an asset as determined by fundamental analysis is known as its fair value. Whether the current market value is priced below or above this fair value is what will influence your trading strategy. For example, you may decide to buy a company’s stock if your fundamental analysis shows it is worth more than the current price. If the market rises to your fair value, you can sell the stock and profit from the move.
Alternatively, your fundamental analysis may also show additional factors as to why a stock is trading below its fair value – such as poor market conditions. So, you might decide to short the asset because those factors show no sign of relenting their influence.
The type of data used to determine an asset’s fair value depends on the asset class you analyse. Decisions of company management can impact a stock’s value while bonds and currencies are influenced by changing interest rates and a country’s balance of trade. The data used in fundamental analysis can be separated into two types: quantitative and qualitative. Knowing how to classify economic data is an important step in performing fundamental analysis.
Quantitative vs qualitative fundamental analysis
Quantitative fundamentals are variables that can be measured or expressed in numbers. They are often pulled from company financial statements and include statistics like revenue figures and current liabilities. Quantitative fundamental analysis is especially helpful when comparing securities in the same asset class such as the performance of several different stocks or commodities.
Qualitative fundamentals include all other factors which can’t be expressed in numbers. Examples include a country’s supply chain issues or consumer sentiment. These qualities are difficult to quantify but can often account for the seemingly unexplained changes in an asset’s price. Qualitative fundamental analysis may be more subjective, so it is most effective when compared evenly across multiple assets.
Neither type of fundamental analysis is distinctly better than the other. You should always consider both quantitative and qualitative fundamentals to better understand the full picture of an asset’s true value.
How to use fundamental analysis
To begin using fundamental analysis, it is often helpful to approach from a bottom-up perspective. This means you first analyse direct influences on an asset such as a company’s growth ratio before expanding your outlook to the market as a whole and eventually the entire economy.
By approaching fundamental analysis from a bottom-up perspective, you ensure the asset has a strong basis on which it can weather market-wide disruptions. For example, if you choose a stock with strong price ratios and a tested business strategy, that asset is less likely to succumb in times of economic turmoil.
A top-down approach can also be used in fundamental analysis to narrow down assets you are interested in trading. This approach is most useful when examining stocks. By first analysing the economy and industry the company belongs to, you know what thresholds company metrics should hit to achieve success.
Fundamental analysis for stocks
Fundamental analysis for stocks includes the examination of company reports and various metrics like revenue, profits, growth and how all of these statistics compare to competitors. As with fundamental analysis of any asset class, it’s also important to look at the wider economy surrounding the asset.
All public companies are required to publish earnings reports at least once a year, but most will release data every quarter. Earnings reports can have a huge impact on the performance of a company’s stock, and if enough companies report negative or positive earnings it can influence the value of major indices or the overall stock market. There are several key elements in an earnings report you should be looking for:
One of the major elements of an earnings report is the company’s income statement. Here you will find a full report of revenue, costs and net earnings along with various calculations of the business’s profit. These include earnings per share, gross margin, gains and losses and a company’s interest payments.
Balance sheets are another piece of earnings reports you’ll want to evaluate. Balance sheets work as a snapshot of everything a company owns and owes at that moment: its assets, liabilities and the claims made by the company investors known as shareholder equity.
Cash flow is a third statement included in earnings reports that details all avenues a company is generating money from to cover its operating expenses, debts and investments. The three components of a company’s cash flow statement are operating activities, investing activities and financing activities.
To learn about all of these elements in more depth and how best to analyse them, check out our comprehensive guide on how to read a company earnings report.
Financial ratios provide qualitative frameworks to analyse figures from a company’s earnings report in order to quickly gauge the health of the company. Below are a few common ratios that can help you begin your fundamental analysis.
- The price-to-earnings (P/E) ratio compares a company’s current share price to the amount earned per share, displaying the cost of each dollar (or pound, euro, etc) of profit. In simple terms, the P/E ratio determines how expensive a share is by looking at the money a business is making.
- The price-to-book (P/B) ratio compares a company’s current share price to its book value per share. The book value per share is the value of a company’s stocks minus its liabilities. A higher P/B ratio means the company is currently valued above its tangible assets and investors likely see worth in its intangible assets such as its patents, customer base or brand image.
- Return on assets (ROA) and return on equity (ROE) ratios evaluate a stock’s performance by comparing a stock’s profit to the cost of its assets in the case of ROA and its equity (assets minus liabilities) in the case of ROE.
You can learn more about ROA, ROE and other useful ratios in our introduction to financial ratio analysis.
Example of fundamental analysis for stocks
In this example of fundamental analysis, let’s evaluate Apple stock. Before we dive into the nitty gritty of Apple’s latest earnings report, let’s analyse the tech industry as a whole.
This can be done by reading reports from trusted publications like the Wall Street Journal, the Financial Times or our own daily analysts’ reports on Apple and other tech stocks.
For example, this preview of Apple’s Q4 earnings report covers the initial low demand for Apple’s newest iPhone and how its sales are likely to be smaller than last Q4’s numbers because of a rocky global economy.
NOTE: When looking at quarterly earnings reports, it’s important to compare the same quarter from consecutive years because seasonal factors can greatly affect sales. Depending on the company, sales may always be stronger during a specific time of year such as autumn and winter when people do holiday shopping, or in the summer season when more people travel.
Predicting a company’s earnings report can be an entire fundamental strategy in itself, as many people like to guess how it may affect a company’s share price and trade the report itself.
So, you may expect Apple sales to be lower this quarter than they were during the same quarter last year. This may or may not be enough to send Apple’s share price lower depending on how large the discrepancy is.
You can also use some financial ratios to judge if Apple’s stock is over or undervalued ahead of the earnings report.
If Apple’s current stock price is $136.53 and its earnings per share (EPS) is $6.05, then its current P/E ratio is 22.57. To understand if this is a high or low ratio, it should be compared to a benchmark or past P/E ratios. If the average P/E ratio of the S&P 500 is higher than Apple’s, say 26.37, it could be a bearish indicator for Apple’s stock price. It tells traders that Apple’s stock may be overvalued* because it has a lower return than the average US company.
This overvaluation coupled with a quarterly earnings report that comes in lower than previous reports of the same quarter may be enough to move Apple’s share price down several points after the earnings report is published.
*It is important to note some stocks have high P/E ratios because of expected future growth. This is especially common with high-profile tech stocks like Apple. However, the older the company is, the more this effect diminishes.
Fundamental analysis in forex
Fundamental analysis in forex involves studying the economic influences of foreign currencies to predict future changes in exchange rates. Economic growth, central bank announcements, business developments, geopolitics and natural weather events in both countries can influence an exchange rate.
A country’s central bank often has the strongest influence on its currency’s value. The bank controls interest rates which in turn affect inflation levels and business transactions throughout the country. There are many reports used to measure inflation, and all are important for forex fundamental analysis. Some of the major indicators are:
- Gross domestic product (GDP), which measures the market value of goods and services produces in a country in months, quarters and years. GDP is used to indicate the general health and near-term growth potential of a country. GDP figures that are higher than projected can strengthen a currency, and GDP that falls below projected estimates may result in a selloff of that currency
- Consumer Price Indices (CPI), which track the price of goods and services in a country. Changes in the CPI measure the degree of inflation over time, which often influences central bank decisions on interest rates and other monetary policies
- Employment reports, which show the net change in employment month-over-month, such as non-farm payrolls. High unemployment may spur the country’s central bank to lower interest rates in an effort to stimulate the economy and create more jobs
All of these metrics should be consulted when conducting fundamental analysis, but not all factors are as concrete as this economic data. Geopolitics like war or sanctions can affect the economic health of businesses, industries, commodities and entire countries. Natural disasters can also deal serious blows to an asset’s price.
Example of fundamental analysis for forex
When using fundamental analysis to prepare for forex trading, most traders start by picking a major currency pair that experiences high liquidity during the hours that best fit their trading schedule. For this example, we’ll look at GBP/USD.
One of the most critical aspects of forex fundamental analysis is knowing the most recent central bank announcements and how they will affect each currency. Central banks are responsible for setting interest rates on a currency in an effort to control its value.
If the Federal Reserve announces it is raising the interest rate, USD can appreciate. If the European Central Bank does not change its own interest rate, then EUR/USD might lower as the US dollar gains against the euro. In this case, you would want to sell EUR for USD in hopes of closing your trade and gaining more euros than you started with.
Often a central bank takes steps to raise interest rates before they announce it, so you may want to read the minutes of central bank meetings. These detailed accounts of the meeting can give you a better idea of what central banks intend to do before they announce it, letting you open a trade before the impacts of the rate hike occur.
Fundamental analysis for indices
Fundamental analysis for indices involves looking at leading stocks and similar indices. Most indices are weighted by market capitalisation, meaning the largest companies influence indices the most.
Your fundamental analysis will also depend on the market an index represents. The FTSE 100, for instance, represents the largest public companies listed on the London Stock Exchange. Data like inflation and unemployment rates for the UK can affect the value of the FTSE 100.
The S&P 500, meanwhile, is heavily weighted for technology and healthcare companies. Legislation or supply chain issues affecting those sectors will influence the index more than other industries.
Fundamental analysis for commodities
Fundamental analysis for commodities is mainly based on levels of supply and demand and the balance of trade between countries.
Qualitative fundamentals for commodities include trade agreements or disputes, industry regulations, supply chains and seasonal or irregular weather events.
Quantitative fundamentals are often easier to gauge for commodities trading through market reports from insight groups or leading commodity exchanges.
Fundamental analysis for bonds
Fundamental analysis for bonds differs depending on the type of bond: corporate bonds or government bonds (gilts). However, both corporate and government bonds are affected by interest rates. Typically, when interest rates rise bond prices go down and vice versa.
Corporate bonds are also affected by the issuing company’s financial health. A company’s inability to repay a bond, represented by its credit rating, can sink the value of its bonds.
Advantages and disadvantages of fundamental analysis
Advantages of fundamental analysis include:
- It’s useful for predicting long-term trends
- It tells traders if an asset is over or undervalued
- It gives insights into the growth potential of stocks
- It can ensure you do not trade on biases or emotions that may cloud your logic when focusing on short-term price action with technical analysis
However, there are some criticisms of the approach, such as:
- It’s not subjective as not everybody interprets the data in the same way
- It doesn’t accurately predict short-term movements, which are better analysed by technical chart analysis
- It is a lengthy process that requires knowledge, not just of a specific asset, but of the economy at large
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- Open a City Index account, or log in if you’re already a customer
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