What do you first look at when considering a new asset for trading? Some tend to pay more attention to fundamental characteristics. Others prefer technical data. While both approaches have their advantages, today we will concentrate on the former and discuss the main ideas around fundamental analysis and how it can be used for trading.
What is Fundamental Analysis?
Fundamental analysis is the process of measuring an asset’s true (also called intrinsic) value. It is conducted through examination of the asset’s financial state and related factors, both internal and external. The goal is to understand whether the asset’s price is correctly evaluated by the market at this moment in time. As a result, a trader should be able to compare his findings with the current market price and conclude whether the asset is overvalued or undervalued. Which, in turn, may present him with a trading opportunity.
Main ideas
The logic behind fundamental analysis is based on the following assumptions:
- The current price of the asset does not reflect its true value according to information available in open sources.
- The value of the asset determined by the fundamental data is likely to be more relevant than the current market price.
- At some point, the market price will come to match the fundamental data.
The majority of data analyzed can be divided into two categories: quantitative (numerical) and qualitative (descriptive, related to quality). The former can be gathered from financial reports with information on revenues, profits, liabilities, that are available to the public. The data can be assessed separately or in comparison with other companies from the same sector/industry or assets with similar characteristics.
Take a look at an extract from the Annual Report of Twitter, Inc. It provides numerical data for the company’s cash flow within the past 3 years. It also offers an opportunity to compare the current financial results to previous periods.
Qualitative data, however, is less tangible and requires a deeper understanding of business models and strategies. It includes behavior patterns of the management – either proving its competence or casting doubt upon its credibility; brand recognition; competitive advantage, customer satisfaction and other factors affecting the overall performance of any business.
For instance, a pharmaceutical company presents a new type of medicine that successfully goes through a series of trials. As a result, it gets a certain advantage over competitors, which will make the stock price go up. This happened with companies that produced vaccines against Covid-19, such as Pfizer, Inc., AstraZeneca plc.
It is important to pay attention to both types of data. Neither qualitative nor quantitative data can provide a full account of a company’s financial health on its own. When examined together, they may offer a more complete image of a company’s or an asset’s present condition and growth potential.
How it works
There are different methods of conducting fundamental analysis for trading. Let’s take a look at two approaches that may be considered the most popular among analytics.
↓ Top-down analysis
According to this method, it is better to first consider macroeconomic factors influencing the state of the economy in general. These include global and regional trade agreements, financial regulations, political instability, unemployment rates, the aftermath of recent natural disasters, etc. A study of economic cycles may also prove to be useful, as it helps understand the overall trend of global economic development. The goal of this first step is to understand which sectors and industries are to benefit from the present conditions.
For example, during the Covid-19 pandemic, the Airline industry suffered as there was a decline in demand for travel. The same happened with the Tourism sector: even the most successful and profitable companies with great financial performance were negatively affected. On the contrary, companies offering online communication services used for remote work like Zoom Video Communications, Inc. greatly benefited from this change, reflected in the rise of the stock price.
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The next stage is the examination of a particular sector and industry that were deemed likely to do well in the future based on macroeconomic analysis. Here it comes down to understanding the main factors affecting this sector. Who are the main players? What drives the competition? What kinds of business cycles do companies go through? Answers to these questions might provide clues as to which business model has a competitive edge. And hint at those with more growth potential compared to other companies from the same sector.
Take the video game industry as an example. There are several big players, such as Sony Interactive Entertainment (owner of PlayStation), Nintendo, Microsoft Corporation. They have good financial results, considerable name recognition and many loyal customers. But there are other factors at play, such as the managements’ strategies, advertising methods, new collaborations and acquisitions of competitors, etc. These may shift the focus from one company to another at any moment and present an interesting opportunity for a perceptive trader.
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Finally, we get to analyze the financial information about the company (or companies) chosen through previous evaluation. To do that, it is important to thoroughly review the company’s financial documentation, mainly balance sheets, income and cash flow statements. These can normally be found among official financial reports published quarterly or annually.
The balance sheet includes records of the company’s assets, liabilities and equity at a certain point in time. The income statement, on the other hand, offers an overview of its performance over a period of time (usually a quarter or a year). It covers revenues, expenses and profit produced for its duration. The statement of cash flows provides data on business activities involving cash.
Financial Ratios
There are particular ratios calculated based on the information in the financial reports mentioned above. They might give a clue as to how well the business is doing at the moment and what its future may look like. There are quite a few different ratios available for analysis. Here are a few that may be considered the most basic and easy to grasp.
- Price-to-earnings ratio (P/E)
It is calculated by dividing the current share price by earnings per share. It gives an opportunity to understand the relative value of the company by comparing it to its past results or other businesses.
- Earnings per share (EPS)
Estimated by dividing a company’s net income by the current number of shares. This ratio indicates how much a company earns per share.
- Debt-to-equity (D/E)
Calculated by dividing the company’s total debt by shareholders’ equity to understand how much leverage is being used and whether there is a risk to shareholders.
- Return on assets (ROA)
To work it out, you divide net profits by total assets. It shows how much profit the company is making for every dollar in assets. Thus providing evidence of how well it is using the existing assets to generate profit.
Though you can challenge your math skills and try calculating these ratios yourself, it is also possible to find them on different websites dealing with financial analytics, such as Investing.com and Finviz. When assessing businesses based on these ratios, make sure to understand the appropriate numbers for each industry, as they might vary.
Source: https://www.investing.com/equities/tesla-motors-ratios
↑ Bottom-up analysis
This approach follows the same steps as the previous one but conducted in the reverse. It involves an examination of all the above-mentioned data, but this time starting from the bottom – revision of the company’s financial statements – and moving up to macroeconomic factors.
Both methods provide a considerable amount of information that can be used to make trading decisions. If you would like to analyze the perspectives of a specific company to understand whether it has the potential to do well in the current economic environment, it would be logical to use the bottom-up approach. However, if you are interested in getting a broader view and taking a look at global factors affecting different industries and companies, starting from the top might provide better results.
Apart from analyzing economic conditions and financial reports, which mostly produce quantitative data, it is also important to pay attention to qualitative data. This includes political and economic news, information about company mergers and acquisitions, changes in management, such as hirings, terminations and even scandals that could affect the company’s reputation. And, in turn, influence its future development. These events may potentially have a bigger impact on the business than information in the financial reports.
As an example, take a look at the price fluctuations of the stock of Activision Blizzard, Inc. over the past year. The first major change occurred after a lawsuit against the company in July 2021. It accused the company of fostering unhealthy work culture, sexual harassment, unequal pay and listed a number of other offenses. The lawsuit was followed by a prolonged investigation into the management’s activities regarding this issue. During it the company’s CEO was accused of concealing information about employee misconduct in November 2021.
Even though the lawsuit wasn’t settled until March 2022, the price bounced back in January 2022. This happened after the announcement of Activision Blizzard’s acquisition by Microsoft Corporation.
When to use fundamental analysis for trading
Fundamental analysis can be used when evaluating different assets to search for both investment and trading opportunities. It may be considered more useful for analyzing long-term trends, as it provides information on potential growth that the current market does not yet fully reflect. But it can also be used for short-term trades. For instance, following the release of financial reports or news affecting the overall prospects of the company and its assets. If you would like to learn more about choosing the best stocks, check out this article with an overview of factors to keep in mind when making trading decisions.
Summing up
Fundamental analysis is an effective method of evaluating the true value of a company or an asset. If used well, it may provide opportunities for trading. But it requires a considerable amount of research and analysis of financial reports, as well as a number of internal and external factors that may affect the price. However, even if done correctly, it does not guarantee a certain success: sometimes it might take some time for the market to catch up and start reflecting the intrinsic value of the asset.
