Introduction to the Fundamental Analysis
AvaTrade strives to ensure that all our traders are well equipped to take on the markets in confidence, with the educational guidance to assist you in better understanding trading and the markets. Let’s take a deeper look into Fundamental Analysis:
What is Fundamental Analysis?
When doing fundamental analysis, a trader studies the overall state of the economy, concentrating mainly on elements closely related to his trade. The research focuses on financial events including those that are remotely related but yet could affect the trade. Political, social and general events can all have a significant influence on the markets.
Understanding Fundamental Analysis
The primary purpose of any fundamental analysis is to determine if an asset is fairly valued or not. If it is not fairly valued based on the fundamental analysis, then the trader can attempt to make a profit by either buying or selling and waiting for the asset to return to fair value. Fundamental analysis is typically a top-down approach, that is it starts from the big picture and works its way down to minor factors to determine the proper valuation of any asset.
That means fundamental analysts will begin by looking at the overall health of the economy. They will then narrow their considerations to the condition of the industry or sector, and finally they turn their attention to the health of an individual stock or other asset.
Any fundamental analysis is conducted using publicly available data. That could be company financial reports for stocks or bonds, or weather and planting reports for agricultural commodities. Each asset has its own specific set of data that needs to be considered when conducting fundamental analysis.
In the case of a stock the analyst would want to look at the earnings of the company, as well as the revenues and the growth of each. They would also look at sales and profit margins, the trends within the industry and within the individual company, and the management forecasts. All of this information is publicly available in the financial statements released by the company.
An investor could also evaluate a bond using fundamental analysis. In this case they would begin by looking at the health of the overall economy, the current interest rates, and the potential future interest rate movements. They would then narrow their analysis to the individual bond issuer, the strength of the business, and any potential change in its credit rating.
While fundamental analysis is best known for its use with stocks, it can be used to evaluate any asset. Whenever you are looking at the broad economy, and publicly available data points and information, then you are performing a fundamental analysis.
Fundamental Analysis vs. Technical Analysis
When delving deeper in to the world of market analysis, the technical versus the fundamental analysis are on contrasting sides of the spectrum. Where a fundamental analysis is conducted, assets and liabilities, earnings and expenses are the most valued, assessed and characterised. On the other hand, in a technical analysis has nothing to do with the numbers game and everything to do with history and how history repeats itself. Looking at past market activity that includes prices and volume.
Deciding which analysis to follow is really up to the trader, it has been a debate for many years and as an educated trader you will need to find the best strategy that works best for you and your trading techniques.
Quantitative Analysis and Qualitative Analysis
There’s a small problem when using the term fundamental analysis, and that problem is that it is considered to be too broad for some. That’s because it can cover anything related to the economic health of a company or other asset. When looking at a stock fundamental analysis covers everything from the actual sales and profits of the firm to the strength of its brand and management team. That’s a lot of information to consider.
As a result analysts have broken fundamental analysis down into two categories. Those are quantitative fundamental analysis and qualitative fundamental analysis. Quantitative fundamental analysis is anything related to data that is shown in numeric form and objective amounts. Qualitative analysis is related to things that are more subjective and unable to be quantified.
To put it more simply quantitative analysis is the hard numbers behind the business. It is the measurable variables such as revenues and profits. As such the most common source of information for quantitative analysis are the financial statements released by each company.
Qualitative analysis deals with things that aren’t clearly measurable such as the management team, the brand strength, and proprietary technology or patents held by the company, among other things.
There is nothing superior about one method of fundamental analysis over the other and many analysts consider both of them together.
Why Conduct Fundamental Analysis?
This type of analysis is for traders who wish to dig deeper into the financial world. It takes a little more time than some traders are willing and able to invest, but should have positive outcomes if done properly. What stands behind any type of analysis is the wish to avoid surprises that might jeopardize the trader’s money. Therefore the deeper the research and analysis, the lower the chances to be taken by surprise. Some of the world’s top traders, who regularly appear on top rich lists employ fundamental analysis. This is defiantly a good track to follow.
We must emphasize that even when conducting a thorough fundamental analysis, there is no guarantee the trade will be successful. The nature of trading any instrument is its relationship to external factors that can impact it, and the fact that the market can dramatically change within minutes, flipping our speculations and changing the fate of our trades.
The Beginnings of Fundamental Analysis
Organized fundamental analysis is thought to have begun with Benjamin Graham, also called the father of fundamental analysis. Besides being considered the father of fundamental analysis he is also consider to be one of the most important and influential people in the history of analysing financial markets.
Scholars look at the beginning of the fundamental analysis movement coming just after the Great Depression, when the book called “Security Analysis” was published by then Columbia Business School professors Benjamin Graham and David Dodd. In the book the two professors warned prospective investors away from the speculative nature of financial markets and instead encouraged them to place their focus on the intrinsic value of assets.
It has been noted over time that the most complete and accurate answer to the question of “What is fundamental analysis” is included in this book.
In the book the authors suggested that the best way to determine the actual value of an asset is through a complete and comprehensive fundamental analysis. The two also suggested that this type of analysis could also be used in forecasting short-term trends in the price of an asset. It’s interesting to note that while today’s investors feel that fundamental analysis has a bias towards long-term forecasting, in the book Graham and Dodd did not place any emphasis on long-term price forecasting, or attempting to use their method to determine the exact future price of an asset.
The book includes chapters that go into great detail to describe various accounting terms and principles, and it has over 300 pages that give methodologies for analysing financial statements completely and accurately. These include an investigation into both company balance sheets and income statements.
In the field of financial market analysis there are few books that have been more seminal or cited by more future authors. And after nearly 90 years the ideas put forward by Graham and Dodd in the book are just as accurate and just as important as they were on the first day the book was released.
How to Perform Fundamental Analysis?
Once you have decided on fundamental analysis as your course of action, we recommend starting by familiarizing yourself with the instrument you wish to trade. All frequent events that can impact your instrument should be taken into account. You should find the right sources to get daily news and make sure to follow them by subscribing to their newsletter and logging on regularly.
One of the main tools of fundamental analysis is to closely follow the economic calendar. It is crucial for a trader to familiarize himself with upcoming financial events involving influential players in the financial arena, such as treasuries, banks etc. One should learn which events are relevant to his trading market, and then detect how to prepare for those events.
What is the importance of Fundamental Analysis?
An example that displays the importance of fundamental analysis can be found with the monthly US unemployed report, called the Non-Farm Payroll (NFP). The NFP usually affects the USD rate, which may lead to changes in the value of other instruments, such as gold trading, crude oil trading and others. Before the NFP is announced by the Bureau of Labor Statistics, traders speculate on the content of the declaration, and based on that calculate their trades. This is called fundamental analysis.
Common Economic Indicators Used
- Unemployment rate
- Interest rates
- New building permits
- Federal funds rate
- Changes in the Gross Domestic Product (GDP)
- Consumer Price Index (Inflation)
- Currency Strength
- Corporate Profits
- Balance of Trade
Criticisms of Fundamental Analysis
Fundamental analysis isn’t without its detractors. Those who adhere to technical analysis often claim that the underlying fundamentals of an asset aren’t necessarily predictive of price. This is because technical analysts believe that the market discounts everything and that any news about a company or asset is already priced in. This means the actual price movement of the asset is far more predictive than any data or news that’s already publicly available.
Another group who disagree with fundamental analysis are the believers in the efficient market hypothesis. Actually, this group disagrees with both technical and fundamental analysis. According to efficient market hypothesis it is impossible for any individual to use any type of analysis to beat the market’s returns. They claim that the market is always efficiently pricing assets such that any opportunity that arises to create a profit is immediately offset by price changes created by the many market participants. Due to this the efficient market hypothesis claims it is impossible for any individual to outperform the market in the long-term.
Fundamental Analysis Tips
To begin employing fundamental analysis, every trader should find a number of informative sources, which will provide him/her with knowledge that will help with fundamental analysis, thus assisting and improving his trades. We invite you to check out our blog, which updates on a daily basis with crucial data relevant to all instruments.
Fundamental analysis FAQ
Why is fundamental analysis so important?
Many investors like to rely on hard numbers, such as earnings or production numbers, when evaluating a stock or other asset. Fundamental analysis can give these traders the hard numbers they need in order to make comparisons and judgments regarding the future price of the asset being studied. So, fundamental analysis is important because it gives us concrete, objective data to work with. By using fundamental analysis, the intrinsic value of a company or an asset type can be fairly evaluated, allowing better trading decisions to be made.
What is top-down vs. bottom-up fundamental analysis?
The top-down approach to fundamental analysis begins by considering the health of the overall economy. It looks at macroeconomic factors such as GDP, interest rates, and inflation levels to determine the overall direction the economy is heading in. It then moves down to look at the sectors and industries within the economy that are performing best, and offering the best trading opportunities. Alternatively, a trader can use the bottom-up approach to fundamental analysis, which starts by looking at individual stocks or assets, and works up to the broader sector and then to the overall economy. Bottom-up analysis is more focused on the microeconomic factors that can impact on markets.
Is fundamental analysis better than technical analysis?
The goal of fundamental analysis is to determine a fair value for an asset or individual stock to see whether it is overvalued or undervalued and whether it should be bought or sold. The goal of technical analysis is to evaluate price action, looking for historical patterns that can help to forecast future price movements. The two methods use quite different hypothesis and methods, and one is not inherently better than the other. Indeed, many successful traders use a combination of fundamental analysis and technical analysis in their trading strategies.