Fundamental analysis involves evaluating a security’s value by examining economic, financial and other factors. This may involve studying a company’s assets, management and niche in the market.
What is Fundamental Analysis?
Before you find a trading opportunity and enter the market with a trade, you need to perform your analysis first. While there are many ways to analyse the market, the most popular are technical analysis and fundamental analysis.
In this article, we’ll cover what fundamental analysis stands for, how to fundamentally analyse a stock and what are the main differences between technical and fundamental analysis.
Intro to Fundamental Analysis
Fundamental analysis tries to identify the true value, or intrinsic value, of a financial instrument. To do so, fundamental analysts have to follow economic indicators such as economic news, interest rates, various financial ratios and future growth prospects for an industry, to name a few.
When analysing these economic indicators, fundamental analysts believe that the imbalance between buying and selling pressure may cause significant price movements in the long term.
The keyword here is “long-term”, as fundamental analysis returns the best results in a time frame of a few weeks to a few months. The reason for this longer-term trading horizon is that, in the short-term, market prices can differ from their equilibrium fundamental level to a large extent. That’s why fundamental analysts usually combine technical analysis for shorter-term trades.
Technical vs. Fundamental Analysis
There are some important differences in the way how technical and fundamental analysts perceive the market.
However, be aware that no type of analysis is better than the other, and successful traders usually combine both technicals and fundamentals to find profitable trading opportunities. Here’re the main differences between technical and fundamental analysis:
- Fundamentals are long-term based – as we already mentioned above, markets need time to reach their fundamental true value. A number of forces work simultaneously in the market, and stock prices can significantly differ from their intrinsic value in the short-term. Technical analysis, on the other hand, can be used in both the long and short run.
- Technical analysts believe that price discounts everything – This is one of the basic premises of technical analysis. Since the price acts immediately on news and external factors, all information one might need to trade the market is already included in the price.
- Technical analysis provides precise entry and exit points – Technical analysts analyse the price chart of a stock, and all potential trade setups have exact entry and exit points. Fundamental analysts, on the other hand, can only predict the direction of the price without having precise entry and exit points.
- All technical tools try to catch the trend – All tools that technical analysts have at their disposal have the main objective to catch a trend in its early stage. To do so, technicians use tools to analyse the price-action, moving averages, chart patterns and support/resistance zones, among others. That’s why technical analysis is very popular among Forex traders – the Forex market simply likes to trend.
Beside following news and important economic indicators, analysing financial ratios is one of the most popular types of fundamental analysis in the stock market.
Most financial ratios rely on data from the income statement, cash flow statement and financial statements of a company, in order to measure the financial health of the company and the true value of its stock.
- Earnings per Share – Among all the fundamental stock analysis tools that, the EPS is the most-widely used. A stock’s EPS is calculated by dividing a company’s net earnings with the number of outstanding shares. The EPS is usually used to compare companies that operate in the same industry, but to find actual trading opportunities, we need to look at other ratios, such as the P/E ratio.
- Price to Earnings Ratio (P/E) – The P/E ratio is calculated by dividing the stock price with the EPS. It gives an idea of how much investors are willing to pay for the company’s earnings. High P/E ratios can suggest that a stock is overpriced, while low P/E ratios can be used to find underpriced stocks. However, low P/Es can also point to a low confidence among investors regarding a particular stock. According to Benjamin Graham’s “Intelligent Investor”, a stock’s P/E ratio should not exceed 15.
- Return on Equity (ROE) – The ROE ratio can be used to see how efficient a company uses its assets to generate earnings. In this regard, the ROE is calculated by dividing a company’s net income by its total book value. All data required to calculate the ROE can be found in a company’s balance sheet and income statement.