Understanding Fundamental Analysis

Before you get involved in trading, you should know how you will analyze the assets you want to trade. Fundamental analysis is amongst the most popular ways to conduct market analysis.

What exactly is fundamental analysis? How does fundamental analysis work? Why should you use it? How do you properly conduct fundamental analysis? Here are some explanations.

WARNING

Trading exposes you to the risk of losing more than your initial investment and incurring financial liability. Trading is suitable only for well-informed, sophisticated clients able to understand how the products being traded work and having the financial ability to bear the aforementioned risk.

Transactions involving foreign exchange instruments (FOREX) and contracts for difference (CFD) are highly speculative and extremely complex. As such, they are subject to a high level of risk due to leverage. Please keep in mind that CFD trading is banned in the US.

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What is Fundamental Analysis?

Fundamental Analysis, a Definition

Conducting fundamental trading means you base your trading decisions on the difference between an asset’s intrinsic value (or “real” value) and its market value.

Therefore, fundamental analysis is a method of determining intrinsic value by analyzing an asset’s financial, economic, social, and political fundamentals.

If the intrinsic value is less than the market value, there is an opportunity to profit by selling the asset short because it is considered overvalued.

On the other hand, if the intrinsic value of a financial instrument is higher than its market value, you can take advantage of this by opening long (or buy) positions because the asset is certainly undervalued.

How do you value a financial asset?

Traders and investors use several asset valuation methods, mainly in the stock market. 

• Evaluation by comparison (comparables approach).
  
  This technique involves comparing an asset with similar assets, for example, comparing one company with another company having a similar profile.
  
  In this case, the company’s financial and operational characteristics must be taken into account, in particular via multiples or financial ratios that provide insight into the asset’s value, such as the price-to-earnings ratio (P/E), the price-to-sales ratio (P/S) and the price-to-book value ratio (P/B).
  
• Evaluation based on DCF (Discounted cash flows).
  
  This technique is based on the fact that a company will always be worth more tomorrow than it is today. The DCF method involves determining a company’s value based on discounted cash flows it will generate in the future.

Fundamental analysis vs. technical analysis

While fundamental analysis focuses on determining an asset’s intrinsic value by considering its fundamentals, technical analysis is based solely on changes in its stock price.

With technical analysis, a trader will chart several price-change variables to determine how an asset will progress.  For this, they will use mainly charting and technical indicators.

Fundamental analysis and behavioral analysis

Fundamental analysis also differs from behavioral analysis, which mainly considers the trader’s psychology, including emotional, cognitive, and psychological factors and biases that guide traders’ decisions.

Accordingly, behavioral analysis provides the trader with a better understanding of overall market sentiment, thus indicating whether it is advisable to buy or to sell the market.

Fundamental Analysis in Different Financial Markets

While some fundamental analysis tools can be used to analyze many financial markets, others are more conducive to specific asset classes.

Fundamental analysis of stocks

Your approach to finding the best stock market opportunities will dictate whether you should focus on either microeconomics or macroeconomics.

In either situation, overall, you should consider data on the economy, the sector, the competitive environment, and the company itself.

Fundamental analysis of stock indices

Whether it is about the DJIA, the NASDAQ, or the FTSE, stock indices often react to the economic outlook.

The more positive the outlook for growth, the higher spending will be, which generally drives up stock prices.

Conversely, when the outlook for growth is negative or uncertain, spending declines, which can take a toll on stock prices. Stock market indices react to any economic news that could change a country’s level of growth.

Of course, not every industry reacts similarly to an economic expansion or downturn. That is why it is always advisable to be familiar with the predominant industries listed in the indices you trade.

For example, while the NASDAQ lists mostly tech stocks, the CAC 40 lists many consumer discretionary stocks.

It is also essential to know the composition of an index. Which stocks, and therefore which industries, influence its value the most.

Fundamental analysis of currencies

The most influential player on the foreign exchange market (FOREX), is typically the central bank. As a matter of fact, through its monetary policy, a central bank influences the amount and value of money in circulation in a given economy.

A central bank influences the supply and demand of money through changes in its interest rate or by intervening in the markets (quantitative easing). This is how one currency will gain or lose ground against another.

Since most central banks aim to ensure price stability, it is necessary to take inflation into account during fundamental analysis.

But you must also consider the employment numbers (NFP ratio, unemployment rate, JOLTS, labor force participation rate), growth (GDP), and the consumer and business confidence indices.

The best tool for that could be the economic calendar which combines all the economic statistics published daily.

Fundamental analysis of cryptocurrency

The cryptocurrency market is relatively new, and its fundamentals are not well known. Nevertheless, there are a few aspects of a blockchain and the cryptocurrency in question that should be considered.

For example, you can consider the change in the number of available tokens compared to the total created, the trading volume, the liquidity of a cryptocurrency or even the number of exchange platforms that offer token trading.

The popularity of a blockchain, the adoption rate and acceptance rate of a currency, the number of addresses created, the hash rate, the competition or the partnerships are also worth considering.

An analysis of the overall market, as well as legislative and regulatory developments will be helpful in better understanding the state of the cryptocurrency market.

Fundamental analysis of commodities

To conduct a fundamental analysis of a commodity, you must first learn which factors influence supply and demand the most. For example, weather and climate will have a particularly significant impact on agricultural commodities.

Certain factors generally influence all commodities, such as the value of the US dollar, the global geopolitical situation, production costs, the level of supplies available, and economic growth.

Top-down Analysis vs Bottom-up Analysis

Top-down analysis and bottom-up analysis are two particularly popular strategies used to determine which companies on the stock market are the best to invest in. 

What is top-down analysis?

Top-down analysis is a method of fundamental analysis that starts with macroeconomic analysis and works its way down to the most promising companies. 

The first step is to study the economic trends of the country in question.

For example, consider the country’s economic growth, interest rates, inflation, and fiscal and trade policy. This will give you an idea of which phase of the business cycle the country is in and which industries to focus on.

Then it is time to examine the different industries to determine the most promising ones. During this step, you can consider market conditions, industry trends, and market forces.

Finally, you will focus on individual companies within each industry to evaluate the best investment opportunities.

What is bottom-up analysis?

Bottom-up analysis is the process of initially analyzing a company’s fundamentals to determine its attractiveness. Therefore, you should first analyze the particular characteristics of the companies you wish to invest in. 

For example, you can analyze its financial performance, level of indebtedness, and growth.

It is also important to consider its products or services, business strategy, competitive advantage, and development projects.

Only then will you look at other criteria, such as industry, or current business cycle, to select the most attractive companies.

With this approach, you analyze companies individually rather than based on overall market movement or industry outlook.

The bottom-up approach considers that some companies may perform well even if their industry is slowing down.

Micro and Macro Analysis

As we have just seen, you can either opt for fundamental analysis that starts with microeconomics (bottom-up approach) or fundamental analysis that starts with macroeconomics (top-down approach)  

What is microeconomic fundamental analysis?

Use fundamental analysis at the microeconomic level when you endeavor to determine the value of a publicly traded company.

This makes it easier to estimate the value of the stocks and bonds of the company involved, and the value of all associated derivatives.

In this case, the analysis will focus on the company’s business and financial figures, the popularity of its products and services, its level of debt, and other factors.

You will not consider the economic environment in which the company operates. 

Your analysis will be based solely on the company’s accounting and financial data. The microeconomic approach to fundamental analysis focuses on evaluating an individual company’s financial performance and fundamentals to determine its intrinsic value and future growth potential.

As a result of such an analysis, it is not uncommon for stocks to be classified either as cyclical or defensive, or growth or value stocks.

What is macroeconomic fundamental analysis?

Fundamental analysis at the macroeconomic level is centered on the economic situation of a country.

This knowledge makes it easier to determine which stock indices, currencies, or sovereign bonds offer the most attractive growth potential.

In this case, you must consider several macroeconomic data points such as growth, inflation, employment, and monetary policy.

The fundamentals of a particular asset are not really taken into account.

The goal is to have a comprehensive understanding of the health of that country’s economy.

Therefore, the macroeconomic approach to fundamental analysis focuses on studying economic indicators and trends (local and international) to understand the economic environment in which assets operate.

This will give you a better idea of emerging trends, macroeconomic risks, and investment opportunities.

What are the Advantages and Limitations of Fundamental Analysis?

Why use fundamental analysis in your trading?

• It provides a better understanding of the asset being traded and how markets generally work.
  
• Fundamental analysis is ideal for investors with a long-term investment horizon.
  
• But it also helps you to better understand the factors that impact markets in the short term based on major trends that may emerge.
  
• Using fundamental analysis helps you better predict long-term trends.
  
• In addition, fundamental analysis helps you identify companies whose share prices are highly undervalued.

What are the risks and limitations of fundamental analysis?

• The results you produce through fundamental analysis can take time to develop.
  
• It is a type of analysis that varies according to the kinds of assets analyzed and can therefore be difficult to master. For example, even within the stock market, many different industries require a unique approach.
  
• It is possible to misinterpret the data being analyzed.
  
• Obtaining transparent, accurate, and truly useful information and data on your target assets may be challenging.

Fundamental analysis seeks to determine whether an asset is correctly valued at a given point in time based on its fundamentals. Since the price of an asset can vary depending on its intrinsic value, any asset whose real value is higher or lower than its market value will create a trading opportunity.