When it comes to trading – whether you’re dealing with century-old stocks or nascent cryptocurrencies – there’s no exact science involved. Or, if there is, Wall Street’s top players ensure that the formula remains a well-kept secret.
What we have instead is a vast array of tools and methodologies employed by traders and investors. For the most part, you can sort these techniques into two categories: fundamental analysis (FA) and technical analysis (TA).
In this article, we’ll dive into the basics of fundamental analysis.
What is fundamental analysis?
Fundamental analysis is a method used by investors and traders to attempt to establish the intrinsic value of assets or businesses. To value these accurately, they’ll rigorously study internal and external factors to determine whether the asset or business in question is overvalued or undervalued. Their conclusions can then help to better formulate a strategy that will be more likely to yield good returns.
For instance, if you took an interest in a company, you might first study things like the company’s earnings, balance sheets, financial statements, and cash flow to get a feel for its financial health. You might then zoom out of the organization to look at the market or industry it’s operating in. Who are the competitors? What demographics is the company targeting? Is it expanding its reach? You could zoom out even further to take into account the economic considerations like interest rates and inflation, to name just a couple of factors.
The above is what’s known as a bottom-up approach: you start with a company you’re interested in and work your way up to understand its place in the broader economy. But you could equally adopt a top-down approach, where you narrow down your picks by first examining the bigger picture.
The end goal with this type of analysis is to generate an expected share price and to compare it with the current price. If the number is higher than the current price, you might conclude that it’s undervalued. If it’s lower than the market price, then you could assume that it’s presently overvalued. Armed with the data from your analysis, you can make informed decisions about whether to buy or sell that particular company’s stock.
Fundamental analysis (FA) vs. technical analysis (TA)
Traders and investors new to the cryptocurrency, forex, or stock markets are often confused over which approach to take. Fundamental analysis and technical analysis stand in stark contrast and rely on significantly different methodologies to analyze different things. And yet, both provide data relevant to trading. So which one is best?
In fact, it might make more sense to question what each brings to the table. In essence, fundamental analysts believe that stock price is not necessarily indicative of the stock’s true value – an ideology that underpins their investment decisions.
Conversely, technical analysts believe that future price movement can be somewhat predicted from past price action and volume data. They don’t concern themselves with studying external factors, preferring instead to focus on price charts, patterns, and trends in markets. They aim to identify ideal points for entering and exiting positions.
Proponents of the efficient market hypothesis (EMH) believe that it’s impossible to consistently outperform the market with technical analysis (TA). The theory suggests that financial markets represent all known information about assets (that they are “rational”) and that they already take into account historical data. “Weaker” versions of the EMH do not discredit fundamental analysis, but “stronger” forms argue that it’s impossible, even with rigorous research, to gain a competitive edge.
Understandably, there is no objectively better strategy out of the pair, as both can present valuable insights into different areas. Some may lend themselves better to certain trading styles, and, in practice, many traders use a combination of both to observe the bigger picture. This is true for short-term trades as it is for long-term investments.
Popular indicators in fundamental analysis
We don’t look to candlesticks, MACD, or RSI for insights in fundamental analysis – there are a handful of FA-specific indicators that are used instead. In this section, we’ll discuss some of the most popular ones.
Earnings per share (EPS)
Earnings per share is an established measure of a company’s profitability, telling us how much profit it makes for each outstanding share. It’s calculated using the following formula:
(net income - preferred dividends) / number of shares
Suppose that a company doesn’t pay out dividends, and its profit is $1 million. With 200,000 shares issued, the formula gives us an EPS of $5. The calculation is not a particularly complex one, but it can provide us with some insight into potential investments. Businesses with higher (or growing) EPS are typically more attractive to investors.
Diluted earnings per share is favored by some, as it also takes into account factors that could increase the total number of shares. In the case of stock options, for example, employees are given the option to purchase company stock. Because this generally gives a higher number of shares to divide the net income, we would expect to see a lower value for diluted EPS versus simple EPS.
As with all indicators, earnings per share should not be the sole metric used to value a prospective investment. That said, it’s a handy tool when used alongside others.
Price-to-earnings (P/E) ratio
The price-to-earnings ratio (or, simply, P/E ratio) values a business by comparing share price with its EPS. It’s calculated with the following formula:
share price / earnings per share
Let’s reuse the same company from the previous example, which had an EPS of $5. Let’s say that each share trades at $10, which would give us a P/E ratio of 2. What does that mean? Well, it depends largely on what the rest of our research shows.
Many use the profit-to-earnings ratio to determine whether a stock is overvalued (if the ratio is higher) or undervalued (if the ratio is lower). It’s a good idea to take the number into account by comparing it with the P/E ratio of similar businesses. Again, this rule doesn’t always hold true, so it’s best used alongside other quantitative and qualitative analysis techniques.
Price-to-book (P/B) ratio
The price-to-book ratio (also known as the price-to-equity ratio or the P/B ratio) can tell us about how investors value the company in relation to its book value. The book value is a business’s value as defined in its financial reports (typically, assets minus liabilities). The calculation looks like this:
price per share / book value per share
Let’s once again revisit our company from previous examples. We’ll assume that it has a book value of $500,000. Each share trades at $10, and there are 200,000 of them. Our book value per share is, therefore, $500,000 divided by 200,000, which gives us $2.5.
Plugging the numbers into the formula, $10 divided by $2.5 gives us a price-to-book ratio of 4. On the surface, this doesn’t look too good. It tells us that shares are currently trading for four times what the company is actually worth on paper. It could suggest that the market is overvaluing the business, perhaps by expecting huge growth. If we had a ratio of less than 1, it would point to the business having more value than the market currently recognizes.
A limitation of the price-to-book ratio is that it’s better suited to the assessment of “asset-heavy” businesses. After all, companies with little physical assets are not well-represented.
Price/earnings-to-growth (PEG) ratio
Price/earnings-to-growth ratio (PEG) is an extension to the profit-to-earnings ratio, expanding its scope to take growth rates into account. It uses the following formula:
price-to-earnings ratio / earnings growth rate
The earnings growth rate is an estimate of the predicted growth in earnings for the company in a set time frame. We express it as a percentage. Suppose that we’ve estimated average growth of 10% over the next five years for our aforementioned company. We take the price-to-earnings ratio (2) and divide it by 10 to reach a ratio of 0.2.
That ratio would suggest that the company is a good investment as it’s heavily undervalued when we factor in future growth. Any business with a ratio of less than 1, generally speaking, is undervalued. Any above could be overvalued.
The PEG ratio is favored over the P/E one by many, as it considers a fairly important variable that P/E omits.
Fundamental analysis and cryptocurrencies
The aforementioned metrics aren’t really applicable in cryptocurrency. Instead, you might look to other factors to assess a project’s viability. In the following section are a handful of indicators used by cryptocurrency traders.
Network value-to-transactions (NVT) ratio
Often regarded as the P/E ratio equivalent of the cryptocurrency markets, the NVT ratio is fast becoming a staple in crypto FA. It can be calculated as follows:
network value / daily transaction volume
NVT attempts to interpret a given network’s value based on the value of transactions it processes. Suppose that you have two projects: Coin A and Coin B. Both have a market capitalization of $1,000,000. However, Coin A has a daily transaction volume worth $50,000, whereas Coin B’s is worth $10,000.
The NVT ratio for Coin A is 20, and the NVT for Coin B is 100. Generally speaking, assets with lower NVT ratios are considered undervalued, while those with higher ratios may be considered overvalued. These merits alone suggest that Coin A is undervalued compared to Coin B.
Some look to the number of active addresses on a network to gauge how much it’s being used. While not reliable as a standalone indicator (the metric can be gamed), it can nonetheless reveal information about network activity. You might factor that into your true valuation of a given digital asset.
The price-to-mining-breakeven ratio is a metric for valuing Proof of Work coins, which are mined by network participants. It takes into account the costs associated with this process: namely, electricity and hardware expenditure.
coin market price / cost to mine a coin
The price-to-mining-breakeven ratio can reveal a lot about the current state of a blockchain network. The breakeven refers to the cost of mining a coin – for instance, if it’s at $10,000, then miners typically spend $10,000 to generate a new unit.
Suppose that Coin A trades at $5,000 and Coin B at $20,000, and both have a breakeven point of $10,000. Coin A’s ratio will be 0.5, while Coin B’s will be 2. Since Coin A’s ratio is under 1, it tells us that miners are operating at a loss to mine the coin. Mining Coin B is profitable as, for every $10,000 spent mining, you would expect to make $20,000.
Because of the incentives, you might anticipate that the ratio would trend towards 1 over time. For Coin A, those mining at a loss would likely leave the network unless the price increased. Coin B has an attractive reward, so you’d expect more miners to join to take advantage of it until it’s no longer profitable.
The effectiveness of this indicator is disputed. Still, it gives you an idea of the mining economics, which you can factor into your overall assessment of a digital asset.
Whitepaper, team, and roadmap
The most popular method for establishing the value of cryptocurrencies and tokens involves some good old-fashioned research into the project. Reading a whitepaper, you can understand a project’s goals, its use cases, and its technology. The track records of team members give you an idea of their ability to build and scale the product. Lastly, a roadmap tells you whether the project is on track. It can be supplemented with additional research to determine the likelihood that the project will hit its milestones.
Pros and cons of fundamental analysis
Pros of fundamental analysis
Fundamental analysis is a robust methodology for assessing businesses in a way that technical analysis simply cannot compete with. To investors worldwide, studying a range of qualitative and quantitative factors is a crucial starting point for any trade.
Anyone can conduct fundamental analysis as it relies on tried-and-tested techniques and readily-available business data. Or at least, this is the case in traditional markets. Indeed, if we look to cryptocurrency (still a small industry), data is not always available, and a heavy correlation between assets means that FA might not be as effective.
Done correctly, it provides a foundation for identifying stocks currently undervalued and poised to appreciate over time. Top investors like Warren Buffett and Benjamin Graham have consistently demonstrated that rigorous research into businesses in this manner can yield tremendous results.
Cons of fundamental analysis
It’s easy to do fundamental analysis, but it’s tougher to do good fundamental analysis. Determining the “intrinsic value” of a stock is a time-consuming process that requires a lot more work than just plugging numbers into a formula. Many factors need to be assessed, and the learning curve for doing so effectively can be steep. What’s more, it’s better suited to long-term trades than short-term ones.
This type of analysis also overlooks powerful market forces and trends that technical analysis can identify. As economist John Maynard Keynes once said:
The market can stay irrational longer than you can remain solvent.
Stocks that appear undervalued (by every metric) are not guaranteed to increase in value in the future.
Fundamental analysis is an established practice that some of the most successful traders swear by. By refining a strategy, investors can not only learn to better estimate the true value of stocks, cryptocurrencies, and other assets but also understand businesses and industries better as a whole.
Combined with technical analysis, fundamental analysis can give traders and investors a well-rounded understanding of which assets and businesses they could profit from. The combination of FA and TA is favored by many in both the legacy and cryptocurrency markets.
Given the nascency of the crypto markets, however, you should understand that FA may not be as effective. Always Do Your Own Research and ensure that you have a solid risk management strategy in place.