Fundamental Analysis in Trading

• Introduction
• Key Concepts
• Tools & Techniques
• Evaluating
• Application

• A fundamental investor will look at a company and say, “I believe this company is going to do well and make more money, so I want to invest in it.” This stands in contrast to other forms of investing, such as value investing or investing based on some form of technical analysis, claiming that the investor can buy an undervalued company in hopes that it will return to its fair value, or that the investor can pick a stock that is going to move in X manner, respectively. Fundamental investors are also typically long-term investors, in that they are investing in the anticipated performance of a company. This is not to say that traders cannot use fundamental analysis to benefit from short-term changes in stock prices, as this can be a very successful method of trading.
  Fundamental analysis is the study of the economic well-being of financial entities. It plays a large role in company valuation and stock selection. The analysis is often used to generate a projection of a company’s future stock price and to determine its current value. The word fundamental is about the data that is analyzed in a company’s financial statements. This data can include revenue, earnings, future growth, return on equity, profit margins, and other relevant data regarding the company. This type of data differs from the “fundamentals” in forex, which would be a country’s interest rate that uses a carry trade. Fundamental analysis is about the financial well-being of a company as opposed to the economic well-being of a country. However, this can involve a country where a company does most of its business or a company that is a large exporter or importer. An example of the latter would be the effect the recent increase in value of the Japanese yen is having on Japanese auto manufacturers, such as Toyota.

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• Fundamental analysis is a complex undertaking. But its basic concepts are not. At the core, it is an examination of the economic, financial, and other qualitative and quantitative factors affecting the price of an asset. Let’s break that definition down: First, there is “an examination”. This indicates a process that is methodical and aims to uncover the reality of the situation, the truth. Many day-to-day decisions are based on gut feeling or intuition; sometimes they are right, and sometimes they’re wrong. The purpose of an examination is to pit what we think is true against what is true. As such, fundamental analysis is less suited to shorter investment horizons, as there might not be sufficient time to determine a discrepancy between an asset’s intrinsic and market values. The timeframe over which fundamental analysis is effective can vary from weeks to years, though the method is most often associated with long-term investments. Next is “the economic, financial, and other qualitative and quantitative factors”. This is broad and includes anything that can affect the value of the asset. It breaks down into two main types of information: Quantitative: Measurable data is used to evaluate an asset. Common sources of data include financial statements, analyst estimates, and growth rates. This information is often abundant, but its interpretation can be complex and non-definitive. An example is calculating the fair value of a stock using a dividend discount model; changing the model’s inputs can greatly alter the calculated value. Qualitative: This information can be harder to find and requires the analyst to use his discretion. Customer and employee reviews, gathering information about the competency and skills of managers, and intangibles such as globalization and industry positioning can all affect price, but in ways that are less direct than the effects of quantitative data. Finally, all of these factors are gauged with the aim of regarding how they affect the price of the asset. This implies that the market is somewhat inefficient in pricing, as an asset’s value obtained from valuing its future cash flows can deviate from its actual market price. A discrepancy between an asset’s intrinsic value and its value on the market is an opportunity for the FA to buy or sell the asset in expectation of the market price moving to the asset’s intrinsic value.

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• Interest rates can be obtained from a country’s central bank, as well as from major financial news sources from around the world. Investors can keep themselves current on GDP figures and other economic data from around the world by getting the information from aforementioned government sources, or from sources such as forex calendars, again which are often available from sources like financial news websites. Various news sources can also provide specific pieces of information on the countries in question. This can range anywhere from elections to other various types of political strife. In this case, tracking the news for any relevant information is a good idea. The same can be applied to natural disasters or any other type of event that may affect a country’s currency. In general, the information needed to analyze a country’s economic situation is widely available from numerous sources, the only aspect that differs is the amount of effort needed to gather the information. Fundamental analysis is the study of the various factors that affect a country’s economy, to determine the underlying value of the currency. Fundamental analysis is often used to analyze changes in the forex market by monitoring figures such as interest rates, unemployment rates, gross domestic product (GDP), and other types of economic data that come out of the countries in question. In the United States, investors can access some reports free of charge on the Department of Commerce website. For other countries, investors can access the information from the countries’ respective central bank or government institution websites, or from sources such as economic calendars which are widely available on the internet, often for free.

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• Publicly traded companies generally must report quarterly (every 3 months) and yearly (once a year) financial statements. These statements can be found in the investor relations section of their website. Looking at revenue over a quarter or a year is a comparison, which can only be done in terms of growth. Comparing the revenue in the most recent quarter to the first quarter is an attempt to compare it with seasonal effects, which usually means April 1. Revenue from 1st quarter to 2nd is compared from April 1 to June 1, and so on. It may also be useful to calculate the growth of revenue every year, to compare it to general economic conditions. This is done by taking the most recent year’s annual revenue and subtracting the last year’s annual revenue, divided by the last year’s annual revenue. Stock-based compensation is a marketing tool used by management, which can burden healthy options for employees. This is because according to generally accepted accounting principles, an employee stock option is considered an expense that must be recognized in the income statement when granted and over the vesting period. To earn this expense becomes a cash expense, companies will often issue stock options exercisable at the market price, transferring equity to employees while not creating cash flow. A general calculation for how this affects earnings is the fully diluted earnings per share is equal to net income (less any preferred dividend), plus the after-tax effect of the stock-based compensation, divided by the weighted average number of common shares outstanding. Stock-based compensation can negatively affect earnings, and the fact that net losses can result in a company still generating positive cash flow can make analysis difficult.

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• Fundamental analysis determines asset value by analyzing factors affecting price. It can be used for long-term price forecasts. Fundamental traders analyze the economy and company financials to determine intrinsic value. Technical traders focus on short-term price movements. Fundamental analysis can be applied to short-term trading as well. Forex market prices are driven by supply and demand influenced by various factors. Fundamental analysis provides an overview of supply and demand forces. Economic indicators help understand a country’s economic state. Effective use of fundamental analysis involves finding a good entry point into a trending market. Experienced traders succeed by considering price movement forces. Traders who take uninformed risks may miss out on forex market potential.

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