What is Fundamental Analysis (FA)?
Basics
Trading weather in established stocks or emerging cryptocurrencies defies an exact science. If there is a secret formula, it remains closely guarded by the elite players of Wall Street. Instead, the trading landscape offers many tools and methodologies embraced by traders and investors alike. These techniques can be categorized into two distinct realms: fundamental analysis (FA) and technical analysis (TA). Within this article, we embark on a journey to unravel the fundamental analysis framework.
What Is a Fundamental Analysis?
The fundamental analysis serves as a crucial method traders and investors embrace to determine the true value of assets or businesses. Through a meticulous examination of internal and external factors, analysts aim to ascertain whether the asset or business is overvalued or undervalued. These insights form the foundation for crafting effective strategies more likely to generate favorable returns.
Suppose you take an interest in a company. In that case, your initial focus would involve delving into critical aspects such as earnings, balance sheets, financial statements, and cash flow to gauge its economic well-being. Zooming out, you would assess the company's market or industry landscape. Who are its competitors? Which demographics does it target? Is it expanding its market presence? Furthermore, expanding your perspective to encompass economic considerations like interest rates and inflation would complete the analysis.
This approach is commonly referred to as a bottom-up approach, starting with a specific company and gradually comprehending its position in the broader economy. Alternatively, a top-down approach can be adopted, where the broader economic context is examined first, leading to a fine selection of potential assets.
The ultimate objective of this analysis is to derive an expected share price and compare it with the current market price. If the calculated value exceeds the prevailing price, the asset is undervalued. Conversely, if the estimated value is lower than the market price, it implies that the asset is currently overvalued. Armed with these analytical findings, informed decisions can be made regarding whether to buy or sell the stock of the analyzed company.
Comparing Approaches: Fundamental Analysis vs. Technical Analysis
Newcomers to the cryptocurrency, forex, or stock markets often face a dilemma when choosing their trading approach. Fundamental and technical analyses offer contrasting perspectives, utilizing distinct methodologies to analyze different aspects. Despite their differences, both approaches provide essential data for trading. So, which one is superior?
Instead of determining a definitive winner, it may be more useful to explore the strengths of each approach. Fundamental analysts, for instance, maintain that stock prices do not always reflect the true value of a stock, shaping their investment decisions around this belief.
On the other hand, technical analysts rely on past price action and volume data to predict future price movements. They disregard external factors and prioritize studying price charts, patterns, and market trends. They aim to identify optimal entry and exit points.
Supporters of the efficient market hypothesis (EMH) argue that consistently outperforming the market through technical analysis is impossible. According to this theory, financial markets incorporate all available information about assets and already account for historical data, assuming a rational state. While "weaker" versions of the EMH do not dismiss fundamental analysis, "stronger" versions claim that gaining a competitive advantage is unachievable even with thorough research.
In reality, there is no objectively superior strategy between the two. Both approaches offer valuable insights into different aspects of trading. Some strategies may align better with specific trading styles, and in practice, many traders combine both approaches to gain a holistic view of the market. This applies to short-term trades as well as long-term investments.
Key Indicators in Fundamental Analysis
Regarding fundamental analysis, traditional technical indicators like candlesticks, MACD, or RSI take a backseat. Instead, specific indicators tailored to fundamental analysis are utilized to gain valuable insights. In this segment, we will delve into selecting the most widely employed indicators in this realm.
Earnings per Share (EPS)
In financial analysis, one key measure that sheds light on a company's profitability is earnings per share. It indicates the amount of profit the company generates for each outstanding share. The EPS calculation involves the following formula:
(net income - preferred dividends) / number of shares
To illustrate, let's consider a scenario where a company has a profit of $1 million and has issued 200,000 shares. Applying the formula, the EPS is determined to be $5. Although the calculation is relatively straightforward, it provides valuable insights for potential investments. Generally, businesses with higher or growing EPS tend to attract investors.
Some analysts also favor diluted earnings per share, which considers factors that could increase the total number of shares. For instance, when employees are granted stock options, it increases the overall share count, resulting in a lower value for diluted EPS compared to simple EPS.
While EPS is a useful metric, it should not be the sole basis for evaluating investment prospects. It is best utilized in conjunction with other indicators to gain a comprehensive understanding.
Price-to-Earnings (P/E) Ratio
In financial analysis, one key valuation metric utilized by investors is the price-to-earnings ratio, commonly referred to as the P/E ratio. This ratio assesses the value of a business by comparing its share price with its earnings per share. The P/E ratio is derived using the following formula:
share price/earnings per share
To illustrate, let's revisit the previous example of the company with an EPS of $5. Suppose each share is trading at $10, resulting in a P/E ratio of 2. However, the significance of this ratio depends on further research and analysis.
The P/E ratio is often employed to ascertain whether a stock is overvalued (if the ratio is higher) or undervalued (if the ratio is lower). It is advisable to consider this figure in relation to the P/E ratios of comparable businesses. Nevertheless, it is important to note that this rule does not always apply universally. Therefore, utilizing the P/E ratio in conjunction with other quantitative and qualitative analysis techniques is prudent.
Price-to-Book (P/B) Ratio
In financial analysis, the price-to-book ratio, also known as the price-to-equity ratio, provides insights into how investors perceive a company's value relative to its book value. The book value represents a business's value as documented in its financial reports, typically calculated by subtracting liabilities from assets. The formula for the P/B ratio is as follows:
price per share/book value per share
Let us revisit our previous company example once again. Assuming the company has a book value of $500,000, with 200,000 outstanding shares trading at $10 each, the book value per share is $2.5 ($500,000 divided by 200,000).
Dividing $10 by $2.5 yields a P/B ratio of 4. This ratio may raise concerns as it suggests that shares are being traded at four times the company's documented value. This could imply an overvaluation by the market, potentially driven by high growth expectations. Conversely, a ratio below 1 would indicate that the business holds more value than is currently acknowledged by the market.
It is important to note that the P/B ratio is more suitable for assessing businesses with significant tangible assets, as companies with minimal physical assets may not frequently appear in the ratio's analysis.
Price/Earnings-to-Growth (PEG) Ratio
In financial analysis, the Price/Earnings-to-Growth ratio serves as an extension of the traditional price-to-earnings ratio, incorporating growth rates into the equation. The formula for calculating the PEG ratio is as follows:
price-to-earnings ratio/earnings growth rate
The earnings growth rate represents an estimated projection of the company's earnings growth over a specific period, typically expressed as a percentage. Let's assume we have calculated an average growth rate of 10% for our previously mentioned company over the next five years. Dividing the price-to-earnings ratio of 2 by 10 yields a PEG ratio of 0.2.
A PEG ratio below 1 indicates that the company is considered undervalued, taking into account its future growth potential. Conversely, a ratio above 1 could suggest overvaluation. Thus, any business with a PEG ratio of less than 1 is generally perceived as undervalued.
Many analysts prefer using the PEG ratio over the price-to-earnings ratio alone, as it incorporates a crucial factor that the P/E ratio overlooks—the consideration of growth potential.
Analyzing Cryptocurrencies: Indicators for Viability
When it comes to cryptocurrencies, traditional fundamental analysis metrics mentioned earlier may not be directly applicable. Instead, cryptocurrency traders rely on alternative factors to evaluate the viability of a project. The subsequent section explores several indicators commonly employed in cryptocurrency analysis.
Network Value-to-Transactions (NVT) Ratio
In cryptocurrency fundamental analysis, a metric equivalent to the traditional P/E ratio has emerged: the Network Value-to-Transactions ratio. This ratio has gained prominence and is now widely utilized in crypto FA. Its calculation involves dividing the network value by the daily transaction volume.
The NVT ratio aims to provide insights into the value of a given network based on the worth of transactions it facilitates. Let's consider two projects, Coin A and Coin B, with a market capitalization of $1,000,000. However, Coin A boasts a daily transaction volume of $50,000, while Coin B's daily volume amounts to $10,000.
In this scenario, Coin A has an NVT ratio of 20, while Coin B has an NVT ratio of 100. Generally, lower NVT ratios indicate undervaluation, while higher ratios may suggest overvaluation. Based on these metrics alone, Coin A appears to be undervalued compared to Coin B.
Active Addresses
In assessing the utilization of a network, some observers turn to the count of active addresses as a gauge of its usage. Although this metric is not entirely dependable as a standalone indicator due to potential manipulation, it can still provide insights into network activity. Incorporating this information into your comprehensive evaluation of a specific digital asset is worth considering.
Price-to-Mining-Breakeven Ratio
The price-to-mining-breakeven ratio is a valuable metric for evaluating Proof of Work coins that rely on network participants to mine them. This ratio considers the expenses associated with the mining process, such as electricity and hardware costs.
To calculate the price-to-mining-breakeven ratio, divide the coin market price by the cost to mine a coin.
This ratio provides insights into the current state of a blockchain network. The breakeven point represents the mining cost per coin. For example, if the breakeven is $10,000, miners typically spend $10,000 to generate a new unit.
Consider Coin A trading at $5,000 and Coin B trading at $20,000, both with a breakeven point of $10,000. Coin A's ratio would be 0.5, while Coin B's ratio would be 2. A ratio below 1, as in the case of Coin A, indicates that miners are operating at a loss. On the other hand, mining Coin B is profitable, as every $10,000 spent mining would yield $20,000.
Over time, the ratio is expected to converge towards 1 due to market incentives. Miners operating at a loss, like those mining Coin A, would likely exit the network unless the price increases. Conversely, Coin B's attractive rewards would attract more miners until it becomes unprofitable.
The effectiveness of this indicator is subject to debate. However, it provides valuable insights into mining economics that can be considered in your comprehensive assessment of a digital asset.
Exploring Whitepaper, Team, and Roadmap
Conducting thorough research into the project remains the most popular approach to assessing the value of cryptocurrencies and tokens. Examining a project's whitepaper gives you insights into its objectives, use cases, and underlying technology. Evaluating team members' track records provides an understanding of their capability to develop and expand the product. Lastly, a roadmap indicates the project's progress and can be supplemented with further investigation to gauge the likelihood of achieving key milestones.
Advantages of Fundamental Analysis: Unveiling the Potential
Fundamental analysis stands as a formidable approach for evaluating businesses, surpassing the capabilities of technical analysis. Investors worldwide recognize the significance of delving into a comprehensive range of qualitative and quantitative factors as a vital initial step in any trading endeavor.
The beauty of fundamental analysis lies in its accessibility to all, relying on proven techniques and easily accessible business data. However, this holds mainly in traditional markets. In the case of cryptocurrency, a nascent industry, data availability is not always guaranteed, and the high correlation among assets may diminish the effectiveness of fundamental analysis.
When executed diligently, this methodology establishes a solid groundwork for identifying undervalued stocks with the potential to appreciate over time. Esteemed investors such as Warren Buffett and Benjamin Graham consistently demonstrate the remarkable results that thorough research into businesses using this approach can yield.
Drawbacks of Fundamental Analysis: Navigating the Challenges
Challenges abound when conducting fundamental analysis, requiring more than mere simplicity. Unveiling a stock's "intrinsic value" is a laborious endeavor that extends far beyond formulaic calculations. Comprehensive assessment of numerous factors demands rigorous effort, and mastering this process effectively can be a formidable learning curve. Furthermore, fundamental analysis finds greater suitability for long-term trades than short-term maneuvers. Furthermore, this approach overlooks the influence of potent market forces and trends, which technical analysis excels at identifying. Echoing the words of economist John Maynard Keynes:
"The market can stay irrational longer than you can remain solvent."
In such a way, even stocks that appear undervalued by every metric offer no guarantees of future value appreciation.
Conclusion
Fundamental analysis, a time-honored practice embraced by accomplished traders, holds immense potential. Through its refinement, investors not only enhance their ability to gauge the genuine worth of stocks, cryptocurrencies, and various assets but also develop a deeper comprehension of businesses and industries at large.
When combined with technical analysis, fundamental analysis bestows traders and investors with a comprehensive understanding, enabling them to identify lucrative assets and businesses. This harmonious integration of FA and TA finds favor among many participants in both traditional and cryptocurrency markets.
Nevertheless, considering the relative novelty of the crypto markets, it is important to acknowledge that FA may exhibit varying effectiveness. To navigate this landscape, always prioritize conducting your own research and establishing a robust risk management strategy.