Fundamental Analysis

There is nothing more valuable than information. The right information used the right way at the right time can achieve incredible results, be it in sports, politics, war or investment. Information for investment purposes falls largely into two categories: fundamental analysis and technical analysis.

This is the Market10 guide to fundamental analysis. Use it to understand how information that is freely available can help you make better decisions on where to invest your money, as well as when to enter and exit a market.

What is fundamental analysis?

Fundamental analysis is a very broad term. It encompasses information on the macro scale like the state of the economy, market sentiment and the position of the industry. Microeconomic factors pertaining specifically to a company like earnings, market share and management are also included and just as important.

Taken together, this data gives analysts an idea of whether a company stock is overpriced or undervalued. If it is the former, the natural response would be to consider selling it; in the case of the latter, it would make sense to buy stock.

While that approach makes sense in itself, the fundamental analysis does not often give black and white answers. Much of the considerations a trader makes, as well as the conclusions he draws from the data, is subjective. It is entirely possible for two analysts to look at the same information and come to opposite conclusions.

At Market10, we place extraordinary emphasis on mathematical models to accurately foresee trends across the stock market, forex, and CFDs (contracts for difference). Fundamental analysis and technical analysis are central to all our financial planning.

Tools of fundamental analysis

From that introduction to fundamental analysis, you can see how complex it can be. However, calculating them on your own gives you an up-close insight into the interrelationships and develops your abilities as a trader.

Here are some of the chief factors you should consider when taking a “do it yourself” approach.

• Price-to-earnings ratio (P/E) – This is a ratio of the current sales price of the company as compared to the company’s per-stock share earnings.
• Price-to-sales ratio (P/S) – Also called sales multiple or revenue multiple, this is a comparison of the company’s stock price against its revenue totals.
• Projected earnings growth (PEG) – This is the growth rate of the company’s earnings over one year.
• Price-to-book ratio (P/B) – Also called the price-to-equity ratio, this is a comparison of a company’s book value to its stock value. The ‘book value’ of a company is its value (cost of assets less deprecation) as calculated in its financial sheets. P/B is obtained by dividing the latest stock closing price by the book value (from the previous quarter).
• Return on equity – Also called return on net worth, this figure is obtained by dividing the company’s net worth by the shareholder’s equity.
• Dividend pay-out ratio – A company may pay out some earnings from its net income to shareholders as dividends while retaining the rest to finance future company growth. This ratio compares how much has been paid out to how much has been retained.
• Dividend yield – This ratio is obtained by dividing the dividend paid out over a year per share to shareholders by the current value of the share. This percentage gives an idea of how much dividend investors can hope to gain for simply investing in the company.
• Earnings per share – This is calculated by dividing the net income, less dividends, by the number of outstanding shares. It gives investors an idea of how total profit relates to each stock share.

There is no doubt that this is a lot to take in, especially if you are a new investor. If you are overwhelmed by the sheer number of variables, the terminology and/or the calculations, Market10 can help.

Tips for fundamental analysis

Good, the reliable fundamental analysis takes time and considerable effort. While much of the information needed for fundamental analysis can be obtained fairly easily, finding the correlation between a financial factor and stock performance can be an elusive goal.

More often than not, no single piece of information can paint an accurate and comprehensive picture of a stock’s value. Virtually all the different pieces of information are interrelated or affected by each other. To gauge whether a stock is overvalued or undervalued, you have to understand these relationships.

To begin, make a list of all the factors to use in your fundamental analysis. They will fall into two (2) categories – macroeconomic and microeconomic – as we discussed earlier.

Within each of these two lists, categorize every factor by the level of direct impact you gauge them to have on stock value. This is an assessment replete with grey areas and your assumptions will affect the ultimate result.

Next, assess how each factor affects the other factors. For example, a booming economy will place upward pressure on a company’s earnings as more people have the cash to buy products that the business produces. Conversely, if the economic boom is occurring but slowing down, the effect on earnings will also decline.

What you should have at the end of your assessment is a web of relationships between every factor. This is just the starting point of your analysis before you trade.

Advantages and Disadvantages

The bulk of the opposition to fundamental analysis lies in its complex calculations and the imprecise manner in which factors are related. Assessments of factors are subjective and can vary significantly between analysts.

Also, as with any data, fundamental analysis cannot anticipate outliers and current events such as the COVID-19 pandemic. However, it also is largely ignorant of the cyclic nature of markets, which is the chief consideration in technical analysis.

The main advantage of fundamental analysis is that it gives a correlation between all the financial figures and the actual value of a stock or share. By taking the fundamentals that affect share price into consideration, you get a clear idea of whether a stock is overvalued or undervalued.

From that point, investing simply comes down to deciding whether you are comfortable with the magnitude of the difference between the actual value and potential value. Naturally, good assessments may place many companies in an intermediate grey area.

Remember, that does not mean that your analysis has been a waste – in fact, following the progress of these ‘grey stocks’ will allow you to identify important factors that you and even expert analysts may have overlooked.

Intelligent investing is all about using information correctly.