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What is Fundamental Analysis (FA)

What is Fundamental Analysis (FA)?

Fundamental Analysis – Whether you’re trading 100-year-old stocks or early cryptocurrencies, there’s no exact science involved when it comes to trading. Or, if any, Wall Street’s best players make sure the formula remains a well-kept secret.

Instead, what we have is a vast array of tools and methodologies used by traders and investors. In most cases, these techniques can be divided into two categories: fundamental analysis (FA) and technical analysis (TA).

In this article, you will learn more about the basics of fundamental analysis.

What is Fundamental Analysis?

Fundamental analysis is a method used by investors and traders to establish the intrinsic value of an asset or business. To accurately assess this, internal and external factors are rigorously studied to determine whether an asset or business is overvalued or undervalued. Their conclusions can help to better formulate strategies that are more likely to yield good returns.

For example, if you are interested in a company, you can first study things like the company’s earnings, balance sheet, financial statements, and cash flow to get a feel for its financial health. You can then zoom out your organization to see the market or industry in which it operates. Who are your competitors? What demographics is your company targeting? Are you expanding your scope? It can be narrowed down further to mention a few factors, taking into account economic considerations such as interest rates and inflation.

The above is what is known as a bottom-up approach. You start with the company you are interested in and work to understand its place in the broader economy. But you can equally adopt a top-down method to narrow down your recommendations by first examining the big picture.

The end goal of this type of analysis is to generate an expected stock price and compare it to the current price. If the figure is higher than the current price, you can conclude that it is undervalued. If it is below the market price, we can assume it is currently overvalued. Armed with analytics data, you can make smarter decisions about whether to buy or sell stocks in specific companies.

Fundamental Analysis (FA) vs. Technical Analysis (TA)

Traders and investors unfamiliar with cryptocurrency, forex, or stock markets are often confused about which approach to take. Fundamental analysis and descriptive analysis are stark contrasts and rely on significantly different methodologies to analyze different things. However, both provide data related to the transaction. So which one is best?

In fact, it might make more sense to ask what each brings to the table. Essentially, fundamental analysts believe that stock prices do not necessarily represent the true value of a stock, but rather an ideology that underpins investment decisions.

Conversely, technical analysts believe that future price action can be somewhat predicted from historical price action and volume data. They don’t mind studying external factors, preferring to focus on price charts, patterns, and market trends instead. They aim to identify ideal points for entry and exit locations.

Proponents of the efficient market hypothesis (EMH) believe that it is impossible to consistently outperform the market with technical analysis (TA) . This theory suggests that financial markets represent all known (reasonable) information about an asset and are already taking into account historical data. A weaker version of EMH does not undermine fundamental analysis, while a stronger form argues that it is impossible to achieve a competitive advantage even with rigorous research.

Naturally, there is no objectively better strategy, as both can provide valuable insight into different areas. Some may be better suited to a particular trading style, and in fact, many traders use a combination of the two to observe the bigger picture. This is true for short-term trading as well as for long-term investing.

Popular Indicators of Fundamental Analysis

We do not consider candlesticks, MACDs, or RSIs to gain insight from fundamental analysis. There are a handful of FA-related metrics that are used instead. This section describes some of the most popular.

Earnings per Share (EPS)

Earnings per share is an established measure of a company’s profitability and tell you how much profit it generates for each outstanding share. It is calculated using the following formula:

(Net Income – Preferred Dividends) / Number of Shares

Assume that the company pays no dividends and has a revenue of $1 million. When 200,000 shares are issued, the formula gives us an EPS of $5. The calculations aren’t particularly complex but can provide insight into potential investments. Companies with higher (or growing) EPS are generally more attractive to investors.

Diluted earnings-per-share is preferred by some because it also takes into account factors that can increase the total number of shares. For example, stock options give employees the option to purchase company stock. Since this usually gives you a larger number of shares to divide your net income, you can expect a lower value for diluted EPS compared to simple EPS.

As with all indicators, earnings per share should not be the only metric used to value future investments. That said, it’s a handy tool to use with others.

Price to Profit (P/E) Ratio

Price-to-earnings ratio (or simply P/E ratio) evaluates a business by comparing its stock price to its EPS. It is calculated by the formula:

stock price/earnings per share

You can reuse the same company from the previous example with an EPS of $5. Each stock trades at $10, which will give us a P/E ratio of 2. What does this mean? Well, that largely depends on what the rest of our study has shown.

Many people use the earnings-to-earnings ratio to determine whether a stock is overvalued (if the ratio is high) or undervalued (if the ratio is low). It’s a good idea to consider the numbers compared to the P/E ratios of similar companies. Again, this rule does not always apply, so it is best used in conjunction with other quantitative and qualitative analysis techniques.

Book (P/B) Ratio to Price

The book-to-price ratio (also known as the stock price-to-equity ratio or P/B ratio) tells how investors value a company in relation to its book value. Book value is the business value defined in financial reports (usually assets minus liabilities). The calculation is as follows:

price per share/book value per share

Let’s take a look at the company again from the previous case. Assume a book value of $500,000. Each stock trades for $10, 200,000 of which are. So, the book value per share is $500,000 divided by 200,000. That would be $2.50.

Substituting the numbers into the formula, $10 divided by $2.5 gives a price-to-book ratio of 4. On the surface, it’s not very good. You can see that the stock is currently trading at four times the actual value of the company. on paper. Perhaps by anticipating massive growth, you can suggest that the market is overestimating the business. A ratio of fewer than 1 points to a business that currently has more value than the market perceives it to be.

A limitation of the book-to-price ratio is that it is more suitable for the valuation of wealthy businesses. After all, companies with few physical assets are not well represented.

Price/Growth to Revenue (PEG) Ratio

The price/revenue-to-growth ratio (PEG) is an extension of the revenue-to-revenue ratio, extending its scope to account for growth rates. We use the following formula:

Price-to-Revenue Ratio / Revenue Growth Rate

Revenue growth is an estimate of a company’s expected revenue growth over a given period. We express it as a percentage. Let’s say you estimate an average of 10% growth over the next five years for the aforementioned company. Divide the price-return ratio (2) by 10 to arrive at a ratio of 0.2.

This ratio is very undervalued given the company’s future growth, suggesting that it is a good investment. Any business with a ratio less than 1 is generally undervalued. The above may be overrated.

The PEG ratio is favored by one over P/E because it takes into account a fairly important variable that P/E omits.

Fundamental Analytics and Cryptocurrency

The aforementioned metrics don’t really apply to cryptocurrencies. Instead, you can look at other factors to evaluate the feasibility of your project. In the next section, there are some indicators used by cryptocurrency traders.

Network Value to Transaction (NVT) Ratio

Often regarded as a P/E ratio on par with the cryptocurrency market, the NVT ratio is becoming an essential component of cryptocurrency FA. It can be calculated as:

Network Value / Daily Volume

NVT attempts to interpret a given network value based on the value of the transaction it is processing. Assume you have two projects (Coin A and Coin B). Both have a market cap of $1,000,000. However, the daily trading volume for Coin A is $50,000 and Coin B is $10,000.

NVT ratio of Coin Ais 20 and NVT of Coin Bis 100. In general, an asset with a low NVT ratio may be considered undervalued and an asset with a high NVT ratio may be considered overvalued. These advantages alone suggest that Coin A is undervalued compared to Coin B.

Active address

Some measure the addresses in use by looking at the number of active addresses on the network . Although not reliable as a standalone metric (the metric is gameable), it can nonetheless reveal information about network activity. You can take this into account in evaluating the true value of a given digital asset.

Mining Breakeven Point Ratio to Price

The mining break-even ratio to price is an indicator for evaluating the proof-of-work coins mined by network participants. Consider the costs associated with this process, namely electricity and hardware expenditures.

Coin Market Price / Coin Mining Cost

The price-to-mining break-even ratio can reveal a lot about the current state of a blockchain network. The Break-even point refers to the cost of mining coins, for example. For example, if it is $10,000, miners usually use $10,000 to create new units.

Assume Coin Atrades is $5,000, Coin Bat is $20,000, and both have a breakeven point of $10,000.Coin As the ratio is 0.5, Coin B is 2. Coin As the ratio is less than 1, so miners are losing money on mining tells you. coin. MiningCoinBis is profitable as it expects to earn $20,000 for every $10,000 in mining costs.

Because of the incentives, we can expect the ratio to move towards 1 over time. In the case of ForCoin A, miners who suffer losses are more likely to leave the network unless the price rises. Coin B offers attractive rewards, so we expect more miners to join until it is no longer profitable.

The effectiveness of this indicator is controversial. It nevertheless gives an idea of ​​the economics of mining that can be taken into account for an overall valuation of digital assets.

White Papers, Teams, and Roadmaps

The most popular way to set the value of cryptocurrencies and tokens involves good old-fashioned research on projects. By reading the white paper, you can understand the project goals, use cases, and technologies. The performance of your team members can give you an idea of ​​your ability to build and scale your product. Finally, the roadmap tells you whether the project is in progress or not. It can be supplemented with further research to determine the likelihood that the project will reach its milestones.

Advantages and disadvantages of fundamental analysis

Advantages of Fundamental Analysis

Fundamental analysis is a powerful method for evaluating a business in a way that technical analysis cannot compete. For investors around the world, studying the various qualitative and quantitative factors is an important starting point for any trade.

It relies on proven technology and readily available business data, so anyone can perform basic analytics. Or at least this is the case with traditional markets. Indeed, if you look at cryptocurrencies (still a small industry), data is not always available and FAs may not be effective if there is a high correlation between assets.

When done correctly, it provides a basis for identifying stocks that are currently undervalued and may be valued over time. Top investors such as Warren Buffett and Benjamin Graham have consistently demonstrated that rigorous study of business in this way can yield tremendous results.

Disadvantages of Fundamental Analysis

Fundamental analysis is easy, but the good basic analysis is hard. Determining the intrinsic value of a stock is a time-consuming process that requires much more work than tying numbers to formulas. Many factors have to be evaluated and the learning curve to do it effectively is steep. It is also more suitable for long-term trading than short-term trading.

This type of analysis also overlooks strong market forces and trends that technical analysis can identify. Economist John Maynard Keynes said:

The market can stay unreasonably longer than you can remain as a solvent.”

An undervalued stock (according to all metrics) is not guaranteed to increase in value in the future.

Final thoughts

Fundamental analysis is an established practice that some of the most successful traders swear by. By shaping the strategy, investors can learn to better estimate the true value of stocks, cryptocurrencies, and other assets, as well as better understand the business and industry as a whole.

The fundamental analysis combined with technical analysis can provide traders and investors with a comprehensive understanding of which assets and businesses can benefit from. The combination of FA and TA is favored by many in both legacy and cryptocurrency markets.

However, given the early stages of the crypto market, it should be understood that FA may not be effective. Always do your own research and make sure you have a solid risk management strategy in place.