Introduction to Fundamental Analysis

Part 7 Introduction to Fundamental Analysis
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What is Fundamental Analysis? Well, it is basically an attempt to understand what something is actually worth. It is trying to understand a market or an asset’s intrinsic value in the present and in the future.

With fundamental analysis the aim is to get ahead of the market by identifying whether an asset is trading below its intrinsic price so you can buy low and sell high. We are not talking about timing here -that’s where Technical Analysis plays a big part.

What we are saying is that we have undertaken a fundamental analysis of an asset, that leads us to believe that it’s future value will be higher than it is now.

In this unit we will cover these key concepts:

  • Top Down vs Bottom analysis
  • Qualitative vs Quantitative analysis
  • Fundamental analysis in different markets

Table of Contents

Top Down Analysis

The top down approach looks at the broad analysis metrics, things such as macro-economics. This would include such things as

  • Interest rates
  • GDP
  • Unemployment rates
  • Inflation
  • Money flows

In a global economy this also very often will include factors such as trade and capital flows (balance of payments) and geopolitical factors.

Going down the scale a bit further, but still top down, this could mean analysing whole market sectors or industries.

The top down approach is good for identifying long term trends or market cycles.

Because of the scale of this analysis, timing is very difficult to get right. However, good top down analysis when applied to investing over the very long term can be profitable.

A good example of this is the Tech sector. Despite the boom and bust of the dot.com bubble of early 2000, the overriding trend of technology was inescapable. Over the subsequent decades, these investments were by far the biggest winners, despite any ups and downs in any one year.

Bottom Up Analysis

A bottom up approach is about focusing on the details and really drilling down into all the factors that can affect an asset on a micro level.

This approach is suited to assets that can be analysed in this level of detail – company stocks being the best example.

This approach can again be divided into two main categories: qualitative and quantitative.

Qualitative

These are the factors that are not easily measured but are still important in determining value. Factors can include:

  • Economic moat: The difficulty for competitors to break into the market.
  • Goodwill and intangible assets: This is the value of that company’s brand, the trust that it’s customers have in it, its reputation and relationships, patents, trade secrets and so on. This may seem hard to quantify but it can be a huge asset. Coca Cola’s Goodwill was valued at over $26B at the end of 2019.
  • Management: Good management can greatly affect a company’s future performance.
  • Technological breakthroughs: In this modern economy technological changes can mean significant market advantages for first movers.

Quantitative

These are all metrics that can be directly measured and comprise the most well known fundamental analysis tools. Again, in the example of company stocks these are factors such as: Assets, Liabilities, Revenue, Earnings, Cash Flow, Momentum (The change in velocity of the key metrics).

These factors, despite being published publicly by many companies can be very difficult to decipher due to the complexity of accounting methods and reporting. As such a range of common ratios or measures are used by investors to get an overview of the soundness and prospects of a company.

Fundamental Analysis For Company Stocks

Fundamental analysis is a key element in the decision making process for investing in individual companies. By investing in successful companies we hope to increase our capital and earn a portion of the profits.

But what makes a company successful? This is more difficult to understand as it is more than just profits. Some of the world’s biggest companies took many years to make a profit and yet still saw their valuations rise.

This is because what a company is worth is more than just its current earnings and profitability, it should also consider its growth potential as well as is debt overhead.

Common Stock Analysis Metrics

There are a range of commonly used metrics for analysing a company’s fundamentals. There are many of them out there but we will highlight some of the most common ones.

These are useful to know as they are readily available for most of the bigger companies and are generally applied in a standard way making comparisons between stocks easier.

Earnings Per Share (EPS):

EPS is net income divided by the number of outstanding shares. This is one of the most simple metrics to show if a company is actually making money.

Price-to-Earnings ratio (P/E):

This ratio compares the current sales price of a company’s stock to its per-share earnings. This is a value metric, a high P/E ratio can be an indication that the market feels that the company is in a growth phase. A low P/E ratio can mean that the company is past it’s growth phase or could mean worry about a stock.

Price to Earnings Growth ratio (PEG):

This takes the P/E ratio further to analyse the growth potential. The PEG ratio is a stock’s (P/E) ratio divided by the growth rate of its earnings for a specified time period. It’s aim is to quantify the growth rate.

Price-to-Sales ratio (P/S):

Also known as sales or revenue multiple, this compares a company’s stock price to its revenues. This can be useful when there is no profit or there are exceptional items which impact profit.

Price-to-Book Ratio (P/B):

The ratio of the share price to net assets.

Dividend Yield:

Dividends are a proportion of the company’s profits that are paid to the shareholders. The dividend yield shows that payment as a percentage of the share price. This gives investors an idea of what that investment would yield as a percentage.

Dividend Cover:

How many times the dividend is covered by earnings.

Retained Earnings:

The ratio of earnings not paid out as dividends. This is money that the company could re-invest for growth or innovation.

Free Cash Flow (FCF):

How much cash the company has after expenses and dividends to fund operations. This is an important metric as cash on hand is what allows the company to pay its operating expenses on a day to day basis (wages and bills).

Debt to Equity (D/E):

A measure of how leveraged a company is – how much debt it has compared to its value.

Fundamental analysis is a time consuming process, but this is fine as investing is a long term goal and as such the time spent on research be it hours or weeks is well worth it when you may hold an investment for years.

Fundamental Analysis In Different Markets

As you can see from the different types of fundamental analysis, you won’t be able to use the same approach for all markets. The tools that you would use to analyse stocks are not the same as you would use to analyse a forex market.

Fundamental analysis can actually be a good way of helping to identify an underlying trend that you can then use as the basis for testing strategies or technical analysis for entries. Let’s look at a forex market example.

Fundamental Analysis Of A Forex Market

An exchange rate between two currencies is actually nothing more than a measure of the demand for one currency in another currency.

An exchange rate between two currencies is a measure of the demand for one currency in another currency.

For example AUD/USD is the measure of the relative demand for Australian Dollars in US Dollars, that is, how many people are looking to buy Australian Dollars with US Dollars or vice versa.

From a top down approach there are two significant factors that can affect an exchange rate:

  • The trade balance and
  • capital flows (together known as the balance of payments).

The trade balance is the amount of goods and services a country sells outside its borders and the capital flows reflect the movement of money to pay for those goods and services.

So, in a country like Australia that has a large amount of commodity based exports, the value of their currency could be affected by macroeconomic factors that affect demand for these commodities.

As such, the AUD is very sensitive to global downturns as this leads to a waning of demand for commodities. If there is a global slowdown in demand, then fewer AUD will need to be bought to pay suppliers in AUS for commodities, leading to a drop in demand for the currency and a likely downward trend developing.

Commodity Currency Pairs

What are the main commodity currencies:

The commodity pairs include pairing the U.S. dollar (USD) with the Canadian dollar (CAD), Australian dollar (AUD), and the New Zealand dollar (NZD). The Russian ruble (RUB), Brazilian real (BRL), and Saudi riyal (SAR) are also currencies sensitive to prices of commodities.
Source: Investopedia

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More Trading Basics

There is loads more to learn and we will uncover more terms in the rest of the Trading Basics blog series. Read our previous or next unit.

Justina Nothard

Justina Nothard

Hi, I’m Justina Nothard, a retail investor trading Stock Index Futures.

I understand how hard it can be for the ordinary trader to learn the basics and find useful tools and practical information.

This is why I decided to create Nothard Trading to help you take control of your trading.

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