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When it comes to trading, whether in the stock market or emerging cryptocurrencies, there is no exact science in this area, or if there is, the top Wall Street players keep the formula as a secret among themselves.
Instead, we have a wide range of tools and methods used by traders and investors. You can classify these techniques into two categories: Fundamental Analysis (FA) and Technical Analysis (TA).
In this article, we will look at the basics of fundamental analysis.
What is fundamental analysis?
Fundamental analysis is a method used by investors and traders to determine the intrinsic value of assets or companies. They carefully study internal and external factors to determine whether the value of their assets or company is above or below its value. Their conclusion can help to adopt a better strategy and thus make a good profit.
For example, if you are interested in a company, you can check the company’s income, balance sheet, financial statements, and cash flow to get enough information about its financial health. Then you need to take a closer look at the market or industry in which the company operates and see who its competitors are. Who is the company targeting? Is it expanding? You can even look at it from a broader perspective to consider economic factors such as interest rates and inflation.
The above is what is known as a “bottom-up” approach. You can start with the company you are interested in and attempt to find its place in a larger economy. You can also take a top-down approach, in which you first limit your options by looking at a larger image.
The ultimate goal of this type of analysis is to be able to predict the price of a stock and compare it to the current price of that stock. If the number obtained is higher than the current price, it can conclude that its value is lower than the actual value. If it is lower than the market price, traders may assume that it is currently overvalued. With the information from such an analysis, you can make informed decisions about buying or selling the company’s stock.
Fundamental Analysis (FA) vs. Technical Analysis (TA)
Traders and new entrants to the cryptocurrency, forex, or stock markets are often confused when choosing their approach. Fundamental analysis and technical analysis are also opposite and rely on different methods. However, both provide trading-related data. So which one is better?
It may be best to ask what information each one provides. Fundamental analysts believe that stock prices do not necessarily reflect the true value of stocks, an ideology that underlies their investment decisions.
In contrast, technical analysts believe that they can predict future price changes in past pricing and volume data.
They do not engage in the study of external factors. They prefer to focus on price charts, patterns, and market trends. Their goal is to identify the ideal points to enter and exit transactions.
Proponents of the efficient market hypothesis (EMH) believe that continuous market tracking with technical analysis is impossible. This theory states that financial markets represent all known (reasonable) information about assets and have historical data in advance.
Understandably, there is no better objective strategy than these two, as both can provide valuable information. Some may have specific trading styles, but in practice, many traders use a combination of both.
Popular indicators in fundamental analysis
We do not look for MACD or RSI charts in fundamental analysis. Also, there are a limited number of indicators for fundamental analysis that traders use. In this section, we will discuss some of the most popular ones.
Earnings per share (EPS)
- Number of shares offered / (Net income – Premium dividends)
Suppose a company does not pay dividends plus its total profit is $1 million. With the release of 200,000 shares, this EPS formula gives us $5. It is not complicated to calculate, but it can provide us valuable information about potential investments. Companies with higher (or growing) EPS are usually more attractive to investors.
Some people are also interested in diluted earnings per share because it considers factors that can increase the total number of shares. For example, in stock options, employees are allowed to buy company shares. Since this generally creates more stocks for the distribution of net income, we expect to see less value for diluted EPS than for average EPS.
By all accounts, EPS should not be the only criterion used to evaluate an investment. This tool is useful when used in conjunction with other factors.
Price to income ratio (P/E)
Calculate the price to earnings ratio (P/E) by comparing its stock price with its EPS. you can calculate P/E by the following formula
- Earnings per share (EPS) / stock price
Let’s use the same company that had the $5 EPS. Suppose each share trades at $10; its P / E ratio is equal to 2. What does this mean? Well, that’s largely dependent on what the rest of our research shows.
Many people use the profit-to-earnings ratio to determine whether stocks are overvalued or undervalued. Again, this rule is not always reliable alone; Therefore, it is better to use it with other quantitative and qualitative analysis techniques.
Price to book value ratio (P/B)
The ratio of price to book value can provide us with information on how a company values its book value to investors. Book value is the business value as defined in a company’s financial statements (typically assets minus liabilities). Its calculation is as follows:
- Book value per share / price per share
Let’s look at the previous company again. Suppose the book value of this company is $ 500,000. Each stock trades at $ 10, and there are $ 200,000 of them. Therefore, our book value will be $ 2.5 per share. So by applying for the numbers in this formula, $ 10 divided by $ 2.5 gives us the price-to-value ratio of $ 4. On the surface, this does not look good.
It tells us that stocks are currently traded four times what the company values on paper. It may indicate that the company’s market has overestimated the company and maybe expecting enormous growth. But if we have a ratio of less than 1, it shows that the company has more value than what the market recognizes.
The limitation of the ratio of price to book value is that it is usually suitable for evaluating “heavy asset” companies and is not proper for companies with low physical assets.
Price-to-income ratio (PEG)
Price/Earnings-to-Growth ratio (PEG) is an additional formula for earnings-to-earnings ratio and considers its scope to account for growth. We can calculate PEG from the following formula
- Profit growth rate / price to income ratio
The income growth rate is an estimate of projected profit growth over a while. We express it as a percentage. Suppose for the above company we estimate an average growth of 10% over the next five years. Now divide the price-to-income ratio (2) by 10 to get a ratio of 0.2.
This ratio shows that the company is good for investment because when I consider its future growth, its value is much lower than its actual value. In general, any company with a ratio of less than 1 is undervalued.
Many prefer the PEG ratio to P / E because it considers a relatively important variable ratio that P / E does not.