Part 1 Fundamental Analysis – Introduction

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Part 1: Introduction to Fundamental Analysis

Dec 23, 1998 2:11 PM EST

As the market relentlessly calls into question virtually every portion of your stock portfolio, even the most independent-minded investor can start doubting himself. You wonder, did I make the right decisions when I bought these stocks? To answer yourself in any rational fashion, you need to be able to judge whether circumstances, not just psychology, have changed for your holdings.

In times like these, strong fundamental analysis becomes key to your conviction. With this in mind, welcome to our five-part series on the how-to of fundamental analysis: what it is, how to read a balance sheet, and how to read an income statement.

As the pundits rant about Russia, rate cuts, devaluation and deflation, you’re probably looking at your now-droopy portfolio thinking, “This is the same bunch of stocks I owned happily a month ago. How did the world get so ugly so fast?”

It’s a good question, because chances are your companies haven’t changed much. It’s investor psychology that has.

You could try to chase that psychology by day trading. Or you could opt out of the daily grind altogether, on the theory that you know your companies’ prospects as well or better than anyone. In the long run you’ll be vindicated. Psychology dissipates, fundamentals endure.

The Internet — long hailed as a day-trader’s dream — actually provides the weapons investors need to do serious company analysis. Sure, the Net can give traders the unprecedented ability to skim teenies off the volatility

from the comfort of their living room. But it also provides investors with nearly unlimited access to the financial data needed for fundamental analysis of a company’s future.

To understand the difference between pure fundamental analysis a la

Warren Buffett

and its day-trading cousin, technical analysis, think of the market as an open-air bazaar with stocks as items for sale. A technical analyst would wade into the shopping frenzy with eyes seeking the crowd. He would ignore the goods for sale altogether.

When the trader notices a group gathering in front of the booth peddling, say, cookware, he’d scramble over to buy as much inventory as possible, betting that the ensuing demand would push prices higher. The trader doesn’t even care what a cast iron skillet is as long as some “greater fool” at the back of the line is willing to buy it for more than the trader paid.

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The fundamentalist, on the other hand, takes a more sedate approach. The fundamentalist’s eyes would be solely on the products before him. He would dismiss the other shoppers as an emotional herd of fools who couldn’t tell a good deal if one slapped them in the face. Once the crowd dissipated from the cookware booth, he might casually wander over to examine the wares.

First the fundamentalist might try to assess the value of the metal contained in a particular skillet if melted down and sold as scrap in order to establish a base price for the object. In the stock market this might be something like figuring out the book value or liquidation price of a company.

Next, the fundamentalist would probably take a close look at the quality of the workmanship to see if it’s going to hold up over time or crack on its first use, just like a stock analyst checks a company’s balance sheet for financial soundness.

Then, he might try to get a handle of the productive capabilities of the skillet in terms of meals cooked or people fed in a manner akin to forecasting future earnings from a company’s income statement.

Finally, the fundamentalist would combine all of the data on the asset to come up with an “intrinsic value,” or a value contained in the object itself independent of the market price. If the market price were below the intrinsic value, the fundamentalist would buy it. If above, the fundamentalist would either sell the skillet he already owned or wait for a better deal.

Fundamental analysis is a lot more work, but therein lies its appeal. Crowd psychology can be a powerful yet fickle force in the markets. As a technician, you’ve got to stay constantly alert or risk getting trampled under feet when the herd reverses direction, as it has lately.

Diving in up to your elbows in the guts of some company to diagnose its prospects, on the other hand, takes the kind of surgical skill and diligence that many traders would just as soon bypass on their way to the rush of more instant chiropractic gratification. As a fundamentalist, however, when you finally do buy a stock that represents a good value, you largely insulate yourself from the day-to-day whimsy of human impulse in favor of longer-term results.

The intrinsic value approach to the markets is based on a couple of big assumptions. The first is that the intrinsic value of an asset can differ from its market price. Purists of the “efficient market hypothesis” find this concept ridiculous. They feel that market price is the

reflection of true value for an asset and reflects all information available about its future prospects at any point in time.

Detractors say the efficiency theory might hold in an ideal laboratory setting. But go out in the real world and things get a little sticky. Information flows get delayed, altered or incompletely disseminated. And more importantly, human beings act on their personal, often illogical, perceptions about the world around them. How else can you explain events like Holland’s classic 17th century tulip fiasco where citizens delirious with speculative fever bid prices for single bulbs up to an equivalent of $40,000 today? Or, more recently, the

Netscape

IPO where traders paid $70 per share or more for a company that has barely showed positive income to this day?

Assuming you accept the notion of intrinsic value, the second big assumption of fundamental analysis is that, even though things get out of whack from time to time, the market price of an asset will gravitate toward its true value eventually. Again, probably a safe bet considering the long upward march of quality stocks in general despite regular setbacks and periods of irrational exuberance. The key strategy for the fundamentalist is to buy when prices are at or below this intrinsic value and sell when they get overpriced.

Figuring out the fair value of a company is the tough part. There are no magic formulas, and a complete understanding of the entire process could take an entire career to develop (and for some analysts, it seems that two lifetimes wouldn’t be enough). For the beginning investor not inclined to do fundamental research, it pays to rely heavily on professional sources like

S&P

stock reports (www.personalwealth.com), and research reports from a broker to get a good fundamental picture of a given company. Why go it alone when there are drones out there who’ve already done much of the work for you?

That said, there’s still a lot that the individual investor can learn about the fundamental process in terms of understanding an analyst’s methodology, terminology, and key indicators, that can make you a more confident consumer of financial information and hopefully a better investor to boot. We’re tackling some of these issues and presenting them to you in a form that should help increase your investing skills.

In part two, we take a look at reading balance sheets: where to find them, what they mean, and what key figures you should look at when analyzing a company. Then, in our third installment, we cover the basics of income statement analysis. In the fourth segment, we pull it all together, and review some good sources for extra reading.

Finally, we wrap the series up with an ongoing Q&A to address any specific reader questions. While we can’t give you an MBA’s worth of financial analysis, we can go a long way toward removing some of the mystery surrounding the process.

Part 1: Fundamental Analysis – Introduction

Today we would like to start a new set of articles that will cover fundamental analysis and the use of global news that work in our favor. Fundamental analysis is an aspect that we shouldn’t avoid and it’s always good to know something about it.

What is fundamental analysis

Unlike with technical analysis, fundamental traders completely avoid all indicators and price action elements and trade, according to the technical traders, irrationally. In this case, the trader tries to predict which direction the market will evolve using facts and the latest news from around the world. Under some circumstances it is very likely that the asset prices will go up or down.

Droughts in Brazil will reduce the price of commodities, such as coffee.

Adverse announcement of unemployment in Switzerland, in turn, reduces the cost of the Swiss franc and therefore, the pair USD / CHF will go up.

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Fundamental news (news releases) can be traded profitably using binary options quite easily. However, it’s important to have all the information needed on hand. Such information includes:

  • When the announcement is done
  • What currency pairs will be affected by the announcement
  • What direction will then the price develop
  • How strong impact will the announcement have

We’ll go through all this points in our series, so make sure you check our website !

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The important news releases (you can find at least a few of them daily) can pretty much mix up your chart, increase or decrease the price even over hundred pips, quite easily within minutes and we could use this in our favour. That’s the reason why I like to trade fundamentals with the broker HighLow that offers 100% profit on all in-money trades.

Broker StockPair

Another broker that I use for trading news releases is stockpair. The main reason is their KIKO binary options, because sometimes the price, based on the predictions, moves greatly only for a few seconds (for example the price increases 100 pips, but within a minute falls again). In such a case, there is no point of entering any long-term positions, but rather grabbing the opportunity of the strong movement and earning a nice profit within seconds.

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The last broker that I like to use for trading based on the world news is 24Option, the reason being very similar to stockpair kiko binary options. The only difference here is that the One Touch options that OptionTime offers have a 250% profit and no penalty, if the price goes the other way in the beginning, as it is with kiko options.

On the other hand, in order to win the trade you need go beyond a greater barrier of pips.

Author

More about the author Step

I’ve wanted to build a business of some kind and earn money since I was in middle school. I wasn’t very successful though until my senior year in highschool, when I finally started to think about doing online business. Nowadays I profitably trade binary options full-time and thus gladly share my experiences with you. More posts by this author

Fundamental Analysis

What Is Fundamental Analysis?

Fundamental analysis (FA) is a method of measuring a security’s intrinsic value by examining related economic and financial factors. Fundamental analysts study anything that can affect the security’s value, from macroeconomic factors such as the state of the economy and industry conditions to microeconomic factors like the effectiveness of the company’s management.

The end goal is to arrive at a number that an investor can compare with a security’s current price in order to see whether the security is undervalued or overvalued.

This method of stock analysis is considered to be in contrast to technical analysis, which forecasts the direction of prices through an analysis of historical market data such as price and volume.

Key Takeaways

  • Fundamental analysis is a method of determining a stock’s real or “fair market” value.
  • Fundamental analysts search for stocks that are currently trading at prices that are higher or lower than their real value.
  • If the fair market value is higher than the market price, the stock is deemed to be undervalued and a buy recommendation is given.
  • In contrast, technical analysts ignore the fundamentals in favor of studying the historical price trends of the stock.

Understanding Fundamental Vs. Technical Analysis

Understanding Fundamental Analysis

All stock analysis tries to determine whether a security is correctly valued within the broader market. Fundamental analysis is usually done from a macro to micro perspective in order to identify securities that are not correctly priced by the market.

Analysts typically study, in order, the overall state of the economy and then the strength of the specific industry before concentrating on individual company performance to arrive at a fair market value for the stock.

Fundamental analysis uses public data to evaluate the value of a stock or any other type of security. For example, an investor can perform fundamental analysis on a bond’s value by looking at economic factors such as interest rates and the overall state of the economy, then
studying information about the bond issuer, such as potential changes in its credit rating.

For stocks, fundamental analysis uses revenues, earnings, future growth, return on equity,
profit margins, and other data to determine a company’s underlying value and potential for future growth. All of this data is available in a company’s financial statements (more on that below).

Fundamental analysis is used most often for stocks, but it is useful for evaluating any security, from a bond to a derivative. If you consider the fundamentals, from the broader economy to the company details, you are doing fundamental analysis.

Investing and Fundamental Analysis

An analyst uses works to create a model for determining the estimated value of a company’s share price based on publicly available data. This value is only an estimate, the analyst’s educated opinion, of what the company’s share price should be worth compared to the currently trading market price. Some analysts may refer to their estimated price as the company’s intrinsic value.

If an analyst calculates that the stock’s value should be significantly higher than the stock’s current market price, they may publish a buy or overweight rating for the stock. This acts as a recommendation to investors who follow that analyst. If the analyst calculates a lower intrinsic value than the current market price, the stock is considered overvalued and a sell or underweight recommendation is issued.

Investors who follow these recommendations will expect that they can buy stocks with favorable recommendations because such stocks should have a higher probability of rising over time. Likewise stocks with unfavorable ratings are expected to have a higher probability of falling in price. Such stocks are candidates for being removed from existing portfolios or added as “short positions.

This method of stock analysis is considered to be the opposite of technical analysis, which forecasts the direction of prices through an analysis of historical market data such as price and volume.

Quantitative and Qualitative Fundamental Analysis

The problem with defining the word fundamentals is that it can cover anything related to the economic well-being of a company. They obviously include numbers like revenue and profit, but they can also include anything from a company’s market share to the quality of its management.

The various fundamental factors can be grouped into two categories: quantitative and qualitative. The financial meaning of these terms isn’t much different from their standard definitions. Here is how a dictionary defines the terms:

  • Quantitative – capable of being measured or expressed in numerical terms.
  • Qualitative – related to or based on the quality or character of something, often as opposed to its size or quantity.

In this context, quantitative fundamentals are hard numbers. They are the measurable characteristics of a business. That’s why the biggest source of quantitative data is financial statements. Revenue, profit, assets, and more can be measured with great precision.

The qualitative fundamentals are less tangible. They might include the quality of a company’s key executives, its brand-name recognition, patents, and proprietary technology.

Neither qualitative nor quantitative analysis is inherently better. Many analysts consider them together.

Qualitative Fundamentals to Consider

There are four key fundamentals that analysts always consider when regarding a company. All are qualitative rather than quantitative. They include:

  • The business model: What exactly does the company do? This isn’t as straightforward as it seems. If a company’s business model is based on selling fast-food chicken, is it making its money that way? Or is it just coasting on royalty and franchise fees?
  • Competitive advantage: A company’s long-term success is driven largely by its ability to maintain a competitive advantage—and keep it. Powerful competitive advantages, such as Coca Cola’s brand name and Microsoft’s domination of the personal computer operating system, create a moat around a business allowing it to keep competitors at bay and enjoy growth and profits. When a company can achieve a competitive advantage, its shareholders can be well rewarded for decades.
  • Management: Some believe that management is the most important criterion for investing in a company. It makes sense: Even the best business model is doomed if the leaders of the company fail to properly execute the plan. While it’s hard for retail investors to meet and truly evaluate managers, you can look at the corporate website and check the resumes of the top brass and the board members. How well did they perform in prior jobs? Have they been unloading a lot of their stock shares lately?
  • Corporate Governance: Corporate governance describes the policies in place within an organization denoting the relationships and responsibilities between management, directors and stakeholders. These policies are defined and determined in the company charter and its bylaws, along with corporate laws and regulations. You want to do business with a company that is run ethically, fairly, transparently, and efficiently. Particularly note whether management respects shareholder rights and shareholder interests. Make sure their communications to shareholders are transparent, clear and understandable. If you don’t get it, it’s probably because they don’t want you to.

It’s also important to consider a company’s industry: customer base, market share among firms, industry-wide growth, competition, regulation, and business cycles. Learning about how the industry works will give an investor a deeper understanding of a company’s financial health.

Quantitative Fundamentals to Consider

Financial statements are the medium by which a company discloses information concerning its financial performance. Followers of fundamental analysis use quantitative information gleaned from financial statements to make investment decisions. The three most important financial statements are income statements, balance sheets, and cash flow statements.

The Balance Sheet

The balance sheet represents a record of a company’s assets, liabilities and equity at a particular point in time. The balance sheet is named by the fact that a business’s financial structure balances in the following manner:

Assets = Liabilities + Shareholders\’ Equity

Assets represent the resources that the business owns or controls at a given point in time. This includes items such as cash, inventory, machinery and buildings. The other side of the equation represents the total value of the financing the company has used to acquire those assets. Financing comes as a result of liabilities or equity. Liabilities represent debt (which of course must be paid back), while equity represents the total value of money that the owners have contributed to the business – including retained earnings, which is the profit made in previous years.

The Income Statement

While the balance sheet takes a snapshot approach in examining a business, the income statement measures a company’s performance over a specific time frame. Technically, you could have a balance sheet for a month or even a day, but you’ll only see public companies report quarterly and annually.

The income statement presents information about revenues, expenses and profit that was generated as a result of the business’ operations for that period.

Statement of Cash Flows

The statement of cash flows represents a record of a business’ cash inflows and outflows over a period of time. Typically, a statement of cash flows focuses on the following cash-related activities:

  • Cash from investing (CFI): Cash used for investing in assets, as well as the proceeds from the sale of other businesses, equipment or long-term assets
  • Cash from financing (CFF): Cash paid or received from the issuing and borrowing of funds
  • Operating Cash Flow (OCF): Cash generated from day-to-day business operations

The cash flow statement is important because it’s very difficult for a business to manipulate its cash situation. There is plenty that aggressive accountants can do to manipulate earnings, but it’s tough to fake cash in the bank. For this reason, some investors use the cash flow statement as a more conservative measure of a company’s performance.

The Concept of Intrinsic Value

One of the primary assumptions of fundamental analysis is that the currently price from the stock market often does not fully reflect a value of the company supported by the publicly available data. A second assumption is that the value reflected from the company’s fundamental data is more likely to be closer to a true value of the stock.

Analysts often refer to this hypothetical true value as the intrinsic value. However, it should be noted that this usage of the phrase intrinsic value means something different in stock valuation than what it means in other contexts such as options trading. Option pricing uses a standard calculation for intrinsic value, however analysts use a various complex models to arrive at their intrinsic value for a stock. There is not a single, generally accepted formula for arriving at the intrinsic value of a stock.

For example, say that a company’s stock was trading at $20, and after extensive research on the company, an analyst determines that it ought to be worth $24. Another analyst does equal research but determines that it ought to be worth $26. Many investors will consider the average of such estimates and assume that intrinsic value of the stock may be near $25. Often investors consider these estimates highly relevant information because they want to buy stocks that are trading at prices significantly below these intrinsic values.

This leads to a third major assumption of fundamental analysis: In the long run, the stock market will reflect the fundamentals. The problem is, nobody knows how long “the long run” really is. It could be days or years.

This is what fundamental analysis is all about. By focusing on a particular business, an investor can estimate the intrinsic value of a firm and find opportunities to buy at a discount. The investment will pay off when the market catches up to the fundamentals.

One of the most famous and successful fundamental analysts is the so-called “Oracle of Omaha,” Warren Buffett, who champions the technique in picking stocks.

Criticisms of Fundamental Analysis

The biggest criticisms of fundamental analysis come primarily from two groups: proponents of technical analysis and believers of the efficient market hypothesis.

Technical Analysis

Technical analysis is the other primary form of security analysis. Put simply, technical analysts base their investments (or, more precisely, their trades) solely on the price and volume movements of stocks. Using charts and other tools, they trade on momentum and ignore the fundamentals.

One of the basic tenets of technical analysis is that the market discounts everything. All news about a company is already priced into the stock. Therefore, the stock’s price movements give more insight than the underlying fundamentals of the business itself.

The Efficient Market Hypothesis

Followers of the efficient market hypothesis, however, are usually in disagreement with both fundamental and technical analysts.

The efficient market hypothesis contends that it is essentially impossible to beat the market through either fundamental or technical analysis. Since the market efficiently prices all stocks on an ongoing basis, any opportunities for excess returns are almost immediately whittled away by the market’s many participants, making it impossible for anyone to meaningfully outperform the market over the long term.

Examples of Fundamental Analysis

Take the Coca-Cola Company, for example. When examining its stock, an analyst must look at the stock’s annual dividend payout, earnings per share, P/E ratio, and many other quantitative factors. However, no analysis of Coca-Cola is complete without taking into account its brand recognition. Anybody can start a company that sells sugar and water, but few companies are known to billions of people. It’s tough to put a finger on exactly what the Coke brand is worth, but you can be sure that it’s an essential ingredient contributing to the company’s ongoing success.

Even the market as a whole can be evaluated using fundamental analysis. For example, analysts looked at fundamental indicators of the S&P 500 from July 4 to July 8, 2020. During this time, the S&P rose to 2129.90 after the release of a positive jobs’ report in the United States. In fact, the market just missed a new record high, coming in just under the May 2020 high of 2132.80. The economic surprise of an additional 287,000 jobs for the month of June specifically increased the value of the stock market on July 8, 2020.

However, there are differing views on the market’s true value. Some analysts believe the economy is heading for a bear market, while other analysts believe it will continue as a bull market.

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