What is fundamental analysis and how to use it in trading?

Fundamental analysis is a technique employed by investors and traders to assess the value of an asset.

Fundamental analysis uses economic data, financial data, and other non-quantifiable data in order to identify the intrinsic value of assets that are not reflected in the current market price.

It is worth noting that fundamental analysis can be applied to any type of asset, including all the financial products you are able to trade with Axi: forex, shares, stock indices, commodities, and cryptocurrency.

 

Key points

• Fundamental analysis is the process of examining the social, political, and economic indicators that might affect the price and performance of a financial asset.
• Fundamental analysts look at the economic factors that affect how an asset performs while technical analysts look strictly at the price and volume through trading charts.
• There are two types of fundamental analysis: quantitative and qualitative.

 

What is fundamental analysis?

Fundamental analysis is the process of examining the social, political, and economic indicators that might affect the price and performance of a financial asset before making investment decisions.

This investment technique can be used to research the underlying businesses that create a product or supply goods and services.

This business research can include examining risks, current management strategies, the company's financial health, financial statements, future growth, historical patterns of performance for products, and competitors' problems to name just a few examples.

The goal of fundamental analysis is to determine whether or not an investment opportunity is currently overvalued or undervalued.

If you find that an asset you are monitoring is trading at an abnormal level and has the potential for gains from purchasing it, then using this type of analysis would be the best approach in order to do your research before investing. Although there may have been a potential gain found, remember that it could also result in a loss.

 

How does fundamental analysis work?

Fundamental investors have a broader scope of what they look at. They will consider how the overall economy, politics, and interest rates can affect an asset’s price or value. 

Technical analysis is more focused on charts that plot movements in prices over time to try and predict future prices based on past patterns. Technical traders utilise technical indicators like moving averages, Fibonacci retracement, and, support and resistance levels to make assumptions on the best time to buy or sell an asset.

 

What's the difference between fundamental and technical analysis?

Fundamental analysts look at the economic factors that affect how an asset performs which can highlight if it is trading higher or lower than its real price value. Public data is used to conduct the analysis from a macro-to-micro perspective. 

Technical analysts look at charts of the price and volume to try and predict where prices will go in the future. When conducting technical analysis the fundamentals are usually ignored and instead, research is based solely on the historical price and value of an asset.

Technical analysis ignores fundamentals and instead focuses on forecasting the direction of prices through historical market data analysis, such as price and volume. 

Technical traders trade on momentum and usually enter into positions of a shorter time span, where fundamental analysts value finding long-term potential.

What is the difference between quantitative and qualitative fundamental analysis?

There are two types of fundamental factors: quantitative analysis and qualitative analysis.

Quantitative fundamental analysis looks at a number of items including financial ratios, market capitalisation, interest rate policies, and earnings per share. The quantitative data is determined by the asset you are researching. These statistics are then used to compare against other similar instruments or industry averages in order to determine how profitable it is.

Qualitative fundamental analysis involves looking at qualitative factors such as management quality, brand recognition, company executives, and proprietary technology. This research relates more to the standard of something, rather than elements that focus solely on numbers like a company's revenue or profit margins.

Many fundamental analysts consider that both qualitative and quantitative analysis work together to provide a more in-depth analysis.

What quantitative fundamentals should you consider in your analysis?

Highlighted below are a few fundamental factors that you should consider when looking at any potential investment opportunity through a quantitative lens. Remember that different assets require research of different fundamentals.

• Market capitalisation 
• Price ratios (earnings per share, price-earnings ratio, price-earnings growth ratio, and price-book ratio)
• Return on investment ratios (return on assets, return on equity, and profit margin)
• Liquidity ratios (current ratio and quick ratio)
• Leverage ratios (debt-equity ratio and interest coverage ratio)
• Efficiency ratios (asset turnover and inventory turnover) 
• Revenue growth rate of the company and its competitors 
• Management quality, including insider holdings and past performance in similar positions
• Financial statements (income statement, balance sheets, and cash flow statements) 
• GDP, CPI, interest rate policies, unemployment rates, inflation

What qualitative fundamentals should you consider in your analysis?

In the list below we have elements of qualitative fundamentals that you need to consider when performing this type of analysis of an asset.

• Company management
• Corporate governance
• Business model
• Competitive advantage and brand recognition 
• Industry of the asset (regulations, market share, customer base, competition)
• Competitors (What are the competitors doing? What is their strategy? How does this compare with the company of the asset you are analysing?)

Many traders conduct both types of analysis when using fundamentals so neither qualitative nor quantitative is better than the other.

 

Top-down vs. Bottom-up fundamental analysis

Fundamental analysis is divided into two different schools of thought:

Top-down fundamental analysis

Top-down fundamental analysis uses the market as a whole and looks at how it should change in order to achieve equilibrium with fundamentals. Since the top-down approach examines the overall market, it is more beneficial for short-term investors who are aiming to make a profit from swings in the market.

Bottom-up fundamental analysis

Bottom-up fundamental analysis, on the other hand, starts from individual companies that are analysed independently before being combined together for an overall view. Bottom-up investors are usually looking for areas to invest in over a longer period of time since through their research they find a strong asset that they believe can perform well even if that particular sector is performing poorly.

Determining intrinsic value

Finding an asset's intrinsic value is one of the most important elements when performing a fundamental analysis of an asset.

Traders use fundamental analysis to determine if a particular asset is overvalued, undervalued, or trading at fair market value. When a bottom-up financial analysis approach is used to examine the available information, the intrinsic value of the asset can be discovered. After they determine the value, the trader can find investment opportunities within the industry.

 

Fundamental analysis tools

These are some of the most important factors you will want to identify and analyse when conducting your fundamental analysis:

• Earnings per share (EPS)
• Price to earnings ratio (P/E)
• Projected earnings growth (PEG)
• Return on equity
• Dividend yield
• Dividend payout ratio
• ​Price to book ratio (P/B)
• Price to sales ratio (P/S)
• Current ratio
• Economic calendar

What are the advantages of fundamental analysis?

There are many advantages of fundamental analysis which has become one of the most popular ways to make investment decisions nowadays. Some people would say that this is because it gives a more accurate picture of what’s going on in the market and so provides clearer signals for trading opportunities but there are also other reasons why fundamental analysis appeals to investors. The financial markets are high risk so insights you find through fundamental analysis are not always going to be 100% accurate.

Some of the key advantages include:

• Using fundamental analysis is a preferred method for long-term investments as it is based on researching long-term trends.
• Fundamental analysis can be a profitable investment tool used to predict what investments will be the best, and these predictions are made far in advance of when an investor needs to make a decision on each investment.
• The more official and popular the news source, the more powerful it will affect the value of the asset.
• Earnings and earnings expectations can offer insight into a company's growth potential which in turn allows investors to pick the best companies and avoid any companies that could be prone to shortfalls.

 

What are the disadvantages of fundamental analysis?

The disadvantages of fundamental analysis are that it might take longer to make a decision because if you want to find out all the latest information on an asset then you’ll need plenty of time and resources. Another disadvantage is that this kind of research does not always take into account how market sentiment can affect prices which means there could be profit opportunities missed.

Some of the key disadvantages include:

• Digging deep into financial reports, balance sheets, and cash flows is crucial but can be a difficult task for investors to undertake. These documents can also be falsified which could end with a trader opening a bad trade.
• When conducting technical analysis there are clear signals when to buy or sell but fundamental factors don't provide that luxury.
• Fundamental analysis is an in-depth approach to assessing currency price trends. It mostly applies to long-term investing, so many short-term trading strategies and trading objectives can't rely on this method of analysis.
• Traders will have to practice good due diligence and need to have a solid understanding of the economy, the industry, and competitors within the industry they are researching. This process can be time-consuming and the insights found may be of no use when markets are reacting quickly.

 

How to perform fundamental analysis

Using forex as an example, the first step to performing fundamental analysis in the markets is to choose the currency pair you want to analyse. Most of the fundamental data you'll need is provided by government agencies and, in most cases, you can access it easily online or find it through an economic calendar. Some of the key fundamental data commonly referred to by traders include trade balance data, microeconomic factors, GDP data, annual reports, current economic well-being, and employment data.

The ultimate goal of fundamental analysis is to determine the current state of a country's economy and assess its future economic prospects. Some key questions to consider when performing fundamental analysis include:

1. Is the country’s economy growing?

Examining a country’s GDP growth over the last four quarters lets you see if there is a pattern of consistent expansion or contraction. Consistent expansion of a country’s GDP is an indicator that its economy is doing well while declining GDP growth is a sign that the economy is underperforming.

2. How high are the Central Bank interest rates?

Depending on whether a country is classified as a developed or developing country, Central Bank interest rates will generally differ. For example, since the 2008 global economic recession most developed countries have had very low interest rates while developing countries have largely maintained quite high interest rate levels. Interest rate levels are usually an indicator of the Central Bank’s confidence in a country’s economy. If rates have been rising, the economy is supposed to be doing well. If they’re declining, the opposite is true.

3. Are inflation levels rising?

A country’s inflation level is a strong indicator of its citizens' buying power, which reflects whether its economic position is considered strong or weak. Citizens with high purchasing power are usually doing better than citizens with low purchasing power. A good measure of inflation is the Consumer Price Index (CPI) data.

4. Is the country politically stable?

The political stability of a country can be assessed from its current political climate as well as its last election. Developing countries with peaceful elections are usually regarded as being more politically stable, as compared to those with elections mired in controversy and violence. Developed countries with stable political processes and strong judiciaries are regarded as being politically stable.

5. What is the country’s employment situation?

What is the country’s current unemployment rate in comparison to past data and is there earnings growth among its working population? Countries with low unemployment rates and substantial earnings growth usually have better-performing economies, as opposed to countries with high unemployment rates and stagnant earnings. Employment and unemployment data is considered to be highly relevant to Fundamental Analysis, as is the jobless claims data.

Does fundamental analysis always work?

No, fundamental analysis doesn’t always work. It can be difficult to predict how the market will react in any given situation and it is not a guaranteed way of making money with any trading strategy. 

Techniques in fundamental analysis can be used across all markets, but while it does provide market insight it is not the only determining factor. Make sure you have a strong trading plan in place for what you do when trades go wrong and practice proper risk management techniques.

Applying fundamental analysis to your trading

When getting started applying fundamental analysis to your daily trading activities, one approach is to focus on assessing the economic releases planned for a given week. You can then begin to identify the releases that are likely to have a significant impact on a particular currency pair. An easy way to isolate such events is to use an economic calendar to see whether they have been classified as high-impact releases.

You can use this information to plan your trades in line with the calendar and your expectations for whether the data meets analysts’ estimates. By analysing historical data you can begin to understand and predict a currency’s possible reaction to economic releases, based on past performance. However, it’s worth remembering that your predictions may not be correct as the markets can move in any direction, so you should expect and plan for it in your trading strategy, which can be implemented through the good practice of risk management.

You should also expect geopolitical events to affect currency pairs, but these are often difficult to anticipate and are best handled through proper risk management.

How to use fundamental analysis in forex?

Fundamental analysis in the forex market involves the analysis of three areas, these are economic events (such as an election or change in legislation), geopolitical events (like the building of a border wall or the way drought affects a population), and social factors (such as demands by a workers union). 

All three factors play a crucial role in the performance of a country’s currency in comparison to its peers. By conducting research across these three areas, information can be found that could help an investor make decisions on trades they may want to open or close.

Examples of key fundamental factors that affect currencies

There are a huge number of factors that affect the performance of individual currencies and affect the strength or weakness of a country’s currency against another. Some of the major fundamental factors include:

• GDP growth rates
• Monetary policy decisions by central banks
• Fiscal policies implemented by governments
• Political statements by leaders
• Employment and earnings figures
• Interest rate announcements
• Trade tariffs and sanctions

How to use fundamental analysis on commodities?

Fundamental analysis is used to predict how supply and demand will affect the price of specific commodities. It can determine what is the intrinsic value of a commodity asset and provide an outlook into its future value.

Qualitative elements in the commodity market are much harder and more complex to assess than quantitative measures. There are a lot of factors that can impact the supply and demand of commodities like weather, industry regulations, trade agreements, and trade wars.

There are reports available in the commodity market that provide quantitative data, such as Commitments of Traders and World Agricultural Supply and Demand Estimates. Traders can use these reports to understand the market fundamentals and make assumptions on future commodity value.

How to use fundamental analysis on indices?

In fundamental analysis, indices are used to determine the sentiment on a particular market. It can be used to predict how traders will react in any given situation, but remember it is not a guaranteed way of making money with any trading strategy. While fundamental analysis provides insight into markets and stock prices, it does not provide all the answers.

Fundamental analysts use macroeconomic data and individual conditions for certain equities that are held within a stock market index. There are a lot of variables that need to be considered like economic factors, share prices within an index, and other macroeconomic factors to determine an index's value.

 

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This information is not to be construed as a recommendation; or an offer to buy or sell; or the solicitation of an offer to buy or sell any security, financial product, or instrument; or to participate in any trading strategy. It has been prepared without taking your objectives, financial situation, or needs into account. Any references to past performance and forecasts are not reliable indicators of future results. Axi makes no representation and assumes no liability regarding the accuracy and completeness of the content in this publication. Readers should seek their own advice.