Lesson 4 - Understanding Fundamental Analysis

Lesson 4 - Understanding Fundamental Analysis

 

What is Fundamental Analysis?

Fundamental analysis (FA) is a technique used by investors and traders to assess and quantify a stock’s value by examining macroeconomic factors such as the state of the economy, as well as microeconomic factors.

The goal of a fundamental analyst is to determine a stock’s fair value; in other words, they aim to conclude whether a security’s current price is underestimated or overestimated. Fundamental analysis contrasts technical analysis, which assesses whether a security’s price will increase or decrease based on historical market data.

What data is used for Fundamental Analysis?

Since financial markets are highly volatile and unpredictable, proper analysis is crucial to determine whether a security is correctly priced on the market. Fundamental analysts will use macro factors (available as public data), such as unemployment rates, gross domestic product and inflation. In addition to this, fundamental analysts will also analyze micro factors such as market mechanisms, good’s relative prices, consumer demand, opportunity cost, etc.

Fundamental analysts will start by assessing the overall state of the economy before moving onto individual company performance. When analyzing a company’s performance, analysts will use a company’s financial statements to understand its revenues, earnings, future growth, return on equity, profit margins, etc. 

In terms of currencies, traders will focus on economic, social, and political forces that can affect a currency’s supply and demand as well as its value. An economic calendar is a useful tool when using fundamental analysis as it offers a daily schedule of planned economic announcements.

How do economic factors affect trading?

Shifts in a country’s economic situation are directly proportional to its currency. Economic factors influence currency rates, which means if the country’s economy is declining, its currency will decline.

 

Interest Rates

As we mentioned previously, interest rates are crucial for foreign exchange prices. While there are many kinds of interest rates, the most important ones for fundamental analysts are nominal/base interest rates established by a country’s central bank, who are responsible for creating the country’s money that is then borrowed by private banks. Nominal/base rates are the percentage that private banks pay for borrowing currencies from central banks. Interest rates are manipulated by countries because they play a significant role in a country’s economy. 

Inflation

Inflation is another vital element in the mechanism of the economy. Every country has its own level of what it considers healthy inflation; for most economies, that’s around 2%. As a country’s economy grows, so should the money in its circulation. Too much inflation can sabotage supply and demand balance, as there will be far too much supply. Yet during deflation, the value of money increases while goods and services become cheaper.

GDP

Gross Domestic Product (GDP) measures the production of all goods and services manufactured within an economy during a given period. It is believed that the rate of change in GDP over a certain period of time is the best indicator of the overall health of an economy.

The lack of economic growth and the local currency’s value is unfortunately not straightforward, since it’s not unlikely for a strong, growing economy to have a weakening currency.

How does Fundamental Analysis benefit investors?

When trading any financial instrument, it is essential to make an educated opinion. Analysts will examine reports that are created based on publicly available data. They then determine an estimated value based on this data. The estimated value is an indicator of what the company's share price should be versus the current trading market price.

When an analyst decides that a security's intrinsic value substantially greater than its current market price, they will rate it a buy or overweight stock. Now, if an analyst finds it to be lower than the current market price, then the security or stock will be considered a sell or underweight. Traders will pay attention to this fact before taking future trading steps. Unfavorable ratings from analysts will have a higher probability of a price decline and may be removed from portfolios.

Fundamental analysis helps traders decide which currencies should be exchanged based on their local economic factors such as inflation and interest rates.

Quantitative and Qualitative Fundamentals

The biggest challenge when using fundamental analysis is that it can cover a broad spectrum of micro or macroeconomic factors.  Due to this, analysts divide factors into groups: quantitative and qualitative. In the financial world, this is defined as:

• Quantitative – Factors that can be measured or conveyed in numerical terms.

• Qualitative – Factors that are related to or built on the quality of something, versus its size or quantity.

Quantitative fundamentals are tangible – they are underlying characteristics that can be measured with accuracy and can be easily found on financial statements. Examples of such characteristics are revenue, profit, and assets. When observing quantitative fundamentals, analysts will seek to understand a company’s financial structure by evaluating its balance sheet. They will also pay close attention to its income statement to analyze the company’s revenues and determine where its cashflows are coming from.

The qualitative fundamentals are less finite and are hard to measure. They are based around a business’ business model, for example:

• What does the company actually do?

• What is its competitive advantage? 

• Does it have strong brand recognition, which offers a strong competitive advantage even during the most volatile economic times?

• Does the company have robust and stable management; after all, every business is as strong as its leaders. 

• What about its corporate governance? Kind of values and policies does the organization have? Do they abide by local corporate laws and regulations? Are they ethical and transparent in the way they execute their business?

What are some criticisms of Fundamental Analysis?

Obviously, the biggest opponents of fundamental analysis are technical analysts.

After all, technical analysis is based on historical data, such as the price and volume movements of stocks. Traders who use technical analysis focus on charting, and they trade on momentum and often ignore the fundamentals. 

Technical analysts believe that an organization’s fundamentals are already embedded in its stock price; therefore, price fluctuations determine them. Therefore, any other data related to the company is considered insignificant. There are also investors who base their trading on efficient market hypothesis, and they disagree with both fundamental and technical analysts.

The efficient market hypothesis claims that it is impractical to make assumptions on the nature of the market through either fundamental or technical analysis. This is because the market prices all stocks on an ongoing basis, which removes any opportunity to outperform the market as any excess returns are instantly captured by the market's countless participants.