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Fundamental analysis is the process of determining the value of something. In trading, that something is an asset, such as stocks. Fundamental analysis isn’t the only way to determine the value of an asset in trading. People often point to technical analysis as the counter to it. We won’t get into the nuances of technical analysis in this guide, but just know that it isn’t the only strategy you can use. It is, however, a popular strategy used by traders and one that allows them to size up the potential value of an asset.
Fundamental analysis is an assessment strategy that focuses on the intrinsic value of an asset. The question you’re asking is, what is the asset’s value and, in turn, is it currently over or undervalued by the market? If it seems as though the asset is overvalued, it might be best to sell. If it’s undervalued, it might be best to buy.
There are other ways of answering this question. Technical analysis is one of these strategies. Technical analysis considers market sentiment and previous price patterns. Fundamental analysis aims to disregard market movements and focus on the core aspects of the asset. In essence, the goal of this type of analysis is to look at the asset in a vacuum.
That doesn’t mean certain outside factors aren’t considered. What we mean is that you’re looking at the asset and the industry surrounding it without thinking about how people are reacting to it. A good way to illustrate this point is to consider what technical analysts look at.
Technical analysis looks at the price history of the asset. These price movements are a reflection of market sentiment i.e. prices rise and fall based on buying and selling activity. When more people are buying, the price is often bullish (i.e. it’s increasing). When more people are selling, the price is often bearish (i.e. it’s decreasing).
With this type of analysis, the decision to buy or sell an asset isn’t always based on its fundamental qualities. For example, let’s say someone was holding Apple stock and they sold. Are they selling because they believe Apple is a bad company without any intrinsic value? Probably not. It’s more likely that the person has sold because they believe the price has peaked and market sentiment is about to change.
Therefore, they’ll sell at a good price and look to rebuy Apple stock at a later date for a cheaper price. This is a fairly simplistic example of how technical analysis works. However, it does demonstrate why a technical analyst will buy or sell. Their decisions are based more on what other people are doing (i.e. market sentiment) because the aim is to ebb and flow with the price movements of an asset.
Fundamental analysis doesn’t consider these movements. In some ways, you could say that it takes a slightly more objective approach to analysing the value of an asset. It’s not completely objective. However, decisions aren’t necessarily influenced by what other buyers and sellers are doing. Of course, as with most things in life, nothing is black and white. There is some crossover and merging of strategies. However, in general, fundamental analysis focuses on the core qualities of an asset as a way of determining its value.
That’s a basic definition of fundamental analysis and how it’s different from technical analysis. Boring down into the details further, this strategy can be split into two main types of analysis:
Quantitative fundamental analysis is all the numbers. It’s the things about a company that can be measured statistically. This means you need to look at a company’s financial statements in order to gauge its position in isolation as well as within the market as a whole.
For example, you can look at a company’s price-earnings ratio (P/E ratio i.e. the current stock price divided by the company’s annual earnings). You can also look at a company’s income, debt and assets owned. Once you’ve got a handle on these metrics, you can compare them to similar companies within the same industry to determine whether the numbers stack up well or not.
Qualitative fundamental analysis looks at qualities that can’t be measured statistically. These can be qualities such as public opinion of the company’s brand, how well established a company is, the people on the board of directors (are the public figures, for example), recent media coverage etc. You could call these qualities the intangibles. They’re the things that you can’t measure statistically but they all contribute to a company’s status and, therefore, value.
Both types of fundamental analysis are useful but, in reality, you can’t have one without the other. It’s possible just to focus on the quantitative or the qualitative. However, for the best results, you should use both.
This is like combining the subjective and the objective or the art and science. You’re using objective statistics in tandem with metrics that are open to interpretation (i.e. subjective). This should, in theory, give you a better overview of an asset and its intrinsic value.
The order you choose to use the two types of fundamental analysis is up to you. However, professional traders go through one of the following processes:
We’ve outlined the central premise of fundamental analysis and how it aims to determine an asset’s value by considering its core qualities. We’ve also touched on some of the metrics you can use and how they fit into the categories of quantitative and qualitative analysis. The final thing to do before we conclude this guide is to provide a snapshot of things to look for when you’re conducting fundamental analysis.
You can use fundamental analysis to assess a variety of financial instruments. We’ve used stocks as an example, but you can also use fundamental analysis for forex, bonds, commodities and indices. The fundamentals of this strategy hold true in all instances.
However, the specific metrics you need to think about change depending on the instrument you’re assessing. So, with this in mind, here are some things to look for when you’re carrying out fundamental analysis on the following:
Indices are baskets of securities. In simple terms, this means an index tracks the performance of multiple stocks. Therefore, you can use the same set of metrics to assess indices as you would stocks. However, it’s important to note that you shouldn’t compare stocks to indices in order to draw comparisons. You should only compare one index to another index.
Jumping straight into a live market and attempting to use fundamental analysis isn’t the best idea. Therefore, if you’re going to use this strategy, it’s important to make sure you understand the fundamentals. Once you’re comfortable with the aims of fundamental analysis and how to do it, try using the Saxo demo account. You then have the ability to try out your own analysis and test out your theories with a virtual bankroll.
Something else you need to accept before you start using fundamental analysis is that nothing is guaranteed. You can assess every part of an asset and come up with what you believe is an accurate value. That’s great and it’s something you should aim for, but unexpected things can and will happen in the markets.
Therefore, you shouldn’t see fundamental analysis as a road to riches. Predicting how the markets will move is tricky at best. So, if you’re going to use fundamental analysis in trading, just remember that it won’t produce definitive answers and guaranteed returns, but it can help you decide whether an asset is over or undervalued.
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Head of Fixed Income Strategy
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