Fundamental Analysis – Definition, Overview, Examples & FAQ

2022-12-30 2022-12-30
Fundamental Analysis in Forex Trading

Michael Hypovhttps://www.litefinance.org/blog/authors/mikhail-hypov/

Fundamental analysis in the stock market is considered to be a complex tool. The most successful investors in history, such as George Soros and Warren Buffett, made up their capitals employing fundamental analysis. This article is an ultimate guide to fundamental analysis in Forex trading. Read on, and you will learn how to utilize the best methods and tools of fundamental analysis!

What is Fundamental Analysis?

Fundamental analysis is a way to predict future asset prices based on external events and facts. These events and facts are the fundamental factors of the economy. Fundamental factors include:

• economic indicators, for example, central banks’ interest rates, Gross Domestic Product (GDP) changes, inflation and deflation rates, employment;

• economic outlook;

• political factors;

• market news and rumors;

• seasonal factors;

• industries’ correlation;

• economic growth, cycles, and other regularities

Fundamental analysis aims to spot the maximum number of essential factors to determine the market’s likely prices.

Fundamental Analysis vs. Technical Analysis: What’s the Difference?

The primary difference between fundamental and technical analysis is in the methods of forecasts. Fundamental analysis suggests a detailed study of the financial and economic indicators of both the subject of the research itself and the outer environment. Technical analysis implies exploring only the price chart to identify patterns or trends, employing a wide range of technical indicators.

Fundamental analysis allows you to identify the fair price of assets and understand how they are undervalued or overvalued at the current time. Fundamental analysis is a method of determining a stock’s real or “fair market” value. The key goal of technical tools is to identify trends and patterns, relevant points to enter and exit trades.

There are also differences in time frames. Fundamental analysis is suitable for long-term investments and fundamental trading, while technical analysis is focused on short-term and medium-term trading opportunities.

Components of Fundamental Analysis

Forex fundamental analysis consists of three key elements:

• Economic analysis;

• Industry analysis;

• Company analysis.

Let us study each of these elements in more detail.

Top-down vs. Bottom-up Fundamental Analysis

There are two major approaches to fundamental analysis in Foreign exchange Forex trading:

Let us explore each of the approaches in more detail:

Top-down Fundamental Analysis

As you see from the above figure, the top-down approach starts with analyzing the global economy and the country’s economy. As a rule, you study factors such as Gross Domestic Product (GDP), the monetary policy of central banks, inflation, interest rate, and the correlation of foreign exchange rates.

After you have analyzed the macro economic indicators, you explore the economic sectors of interest and particular industries. Based on the research, you can choose the most promising investment options. At the final stage, you carry out a fundamental analysis of individual companies’ stocks.

Bottom-up approach

As you see from the above figure, the bottom-up approach suggests analyzing data in the opposite order. That is, you first analyze the securities of a company, its financial statements; next comes the industry and economic sector. At the final stage, you explore the macroeconomic factor relative to the selected companies.

Investors employing the bottom up approach usually believe that particular securities could work out better than the industry or an economic sector as a whole. They explore in detail the current and future performance of each selected company to invest in the most promising assets.

Quantitative and Qualitative Fundamental Analysis

The various fundamental factors can be grouped into two categories: quantitative and qualitative.  Quantitative forex fundamental analysis involves researching the securities market based on statistical and financial data, as well as measurable characteristics of a business. Quantitative analysis is often employed in algorithmic trading strategies to manage significant risks and assess the potential return on investment portfolios.

The fundamental qualitative analysis explores less tangible data. They could be political and economic relations between countries, corporate culture, consumer expectations, brand-name recognition, the correlation between different processes and patterns. For example, a trader likes the company’s products, like Apple, or the company’s key executives, like Tesla. 

Key performance indicators

There is no strict algorithm to analyze economic data. I can define particular fundamental indicators, which are key performance indicators or KPI. Some financial performance indicators are:

• The ROE indicator;

• The P/E ratio;

• The Beta coefficient– Beta (β);

• Earnings per share (EPS);

• Price/Balance ratio – (P/B Ratio);

• The PEG ratio;

• P/S ratio;

• The dividend payout ratio;

• The dividend yield.

All these indicators convey the information on some economic processes. By comparing these factors, the investor assesses the performance of the company or the industry. So, the trader reduces the risks of making a losing transaction.

Return on Equity (ROE)

The return on equity is one of the critical elements of forex fundamental analysis. It determines how efficiently the company uses the capital of its shareholders. The ROE is calculated by dividing equity capital by the company’s net profit using the formula:

ROE = Net_Income/Equity * 100%, 

Where:

For example, if the company earned 10 million euros this year, and the equity is 100 million, the return on equity will be:

ROE = 10 000 000/100 000 000 * 100% = 10%.

The indicator is useful when comparing participants in the same industry or the dynamics of ROE changes over several years. It makes no sense to compare companies from different sectors in terms of this indicator. The specifics of the market have a strong influence on the company’s profitability.

Price-to-Earnings Ratio (P/E Ratio)

Investors use the Price-to-earnings (P / E) ratio in forex fundamental analysis to evaluate companies. It determines how much their stock is undervalued or overvalued. To calculate it, you need to divide the current share price by earnings per share. The latter is calculated by dividing the annual profit by the number of securities issued.

P/E ratio is calculated according to the formula:

P/E = Price / EPS, 

Where:

Sometimes, the price to earnings ratio is described in trading as the company’s capitalization. It means the total relative value of all securities divided by the net profit. The information provided by the indicator and total value or the shareholders equity won’t change.

In practice, the P/E ratio is often calculated using the expected net profit. This happens when the company’s analysts project the net profit. In this case, the market will consider the expected profit, and the P/E will be revised.

Beta (β)

A beta coefficient in forex fundamental analysis measures the correlation of an asset to movements in the overall market or industry. It means how the asset price depends on the general market tendencies. For example, a stock could be compared to a benchmark stock index, such as NASDAQ or S&P 500.

Beta coefficient calculation formula: 

Where:

• Cov (k, p) – covariance of the return;

• k_i – the return of individual stock i;

• p – the return of the portfolio.

For you to understand it better, I will present another, more complex formula:

Where:

• k ̀ – expected (average) stock return;

• p_i – i-portfolio return (a stock index return over period i)

• p ̀ – expected (average) portfolio return;

• n – the number of observations.

Coefficient values:

• More than 1. The stock price correlates (moves in the same direction) with the stock index. The stock is more sensitive (rise or fall faster) to the stock index’s value changes.

• The Beta of a stock equals to 1. The stock’s price movements repeat the movement of the index with 100% accuracy.

• From 0 to 1. An individual stock correlates with the stock index. The stock price is less sensitive to the stock index.

• The Beta is 0. The stock doesn’t correlate with the index. It means the relative value of an individual stock doesn’t depend on the stock index price movements.

• From -1 to 0. The stock price has a negative correlation with the stock index. It means the individual stock moves in the opposite direction of a stock index. The equity’s price is less sensitive to the average market moves than the stock index.

• Less than – 1. The stock has a negative correlation with the index. The volatility of such equity is higher than that of a stock index.  

Earnings Per Share (EPS)

EPS shows the company’s profitability. It is calculated by dividing the company’s net income by its total number of outstanding shares.

EPS = NetIncome/TCSO, 

Where:

In some types of analysis, to estimate the shares of the companies with complex capital structure, Diluted EPS is used. The difference from the usual EPS is that the net profit is divided by the adjusted number of shares. Securities such as convertible options, warrants, bonds are deducted from the base number of common shares.

Price-to-Book Ratio (P/B Ratio)

Price-to-Book Ratio (P/B Ratio) helps determine if the company’s stock is undervalued compared to its intrinsic value. The P/B ratio compares a company’s market capitalization, or market value, to its book value. Book value is the value of the company’s total assets without total liabilities.

The P/B formula:

P/B = Price/BVR,

where:

P/B shows what property the investor will acquire by investing a notional dollar in the firm. It is close in meaning to book value per share.

Price-Earnings-Growth Ratio (PEG)

PEG is a variation on the previously discussed P/E Ratio. The multiplier is calculated by the formula:

Where:

The multiplier considers the expected future return. It is used to determine the appropriateness of the price that an investor is willing to pay for income growth in the future.

Price-to-sales ratio (P/S)

The P/S ratio measures the volume of sales. It is calculated using the formula:

P/S = Price/Sales_Ratio, 

Where:

The P/S ratio helps to understand how much an investor should pay for each dollar received from sales. The nature of this parameter is similar to the P/E ratio. However, it is thought to be less accurate since it does not take into account operating costs. Nonetheless, the volume of retail sales updates more often and is easier to predict.

Dividend Payout Ratio

The Dividend Payout Ratio is the percentage of earnings paid to shareholders in dividends. 

The common calculation formula looks like this:

DPR = Total_Dividents/Net_Income, 

where:

Using this coefficient, you can determine the company’s dividend policy and indirectly estimate a security yield.

Dividend Yield

The dividend yield, expressed as a percentage, is a financial ratio (dividend/price). The DY shows how much a company pays out in dividends each year relative to its stock price. The reciprocal of the dividend yield is the price/dividend ratio.

The dividend yield is calculated according to the formula:

DY = Dividend/Price of share * 100%

Dividend Yield is a convenient way to measure the cash profit made from every dollar invested. Or, to put it simply, the return on the investment.

Examples of Fundamental Analysis

Let me explain the evaluation of the financial key indicators on the example of Microsoft.

So, over the past year, the value of MSFT stocks has increased significantly despite the pandemic and lockdowns. At the same time, over the past three months, the price has varied within +/- 4%. I would like to know how the Microsoft stock price will change in the future.

I use the free services produced by simplywall.st and see that the P/E ratio, measuring the payback period for MSFT is 34.1 years (blue arrow). It is shorter than the average payback period in the industry, 51.4 years (turquoise arrow). On the one hand, it means that the stock is potentially undervalued. On the other hand, it could suggest possible fundamental problems limiting the demand for the stocks and pressing down the cash flows.

The chart also represents the P/E of the market, but it makes no sense to compare the previous data with these ones. The average market P/E indicates the overall state of overbought of the high tech industry in general, rather than of a particular company. 

The PEG of 3.2 is a low value. It means that the high market price of the Microsoft stock pays back only partially.

The P/B value is 13.1. It is more than six-fold greater than the US market average and 1.5 times more than the industry average. High P/B means that the Microsoft stock is overvalued.

The return on equity (ROE) is also high, at 38.5%. The average ROE in the industry is 12.6%.

Having explored the key performance indicators, I can suggest that Microsoft stocks are valued higher than the market. High ROE and steady long-term uptrend mean that investors are optimistic and expect the company’s stock’s future growth. With this regard, the MSFT P/E is lower than the average industrial indicator. 

So, the stock is undervalued compared to the rivals, and its true value could be higher. So, using fundamental analysis valuation, I could recommend buying the Microsoft stocks. 

The Best Research Tools for Fundamental Analysis

It is difficult to carry out the fundamental analysis in Forex market, stock, or futures market if you manually calculate all the indicators. Currency pairs technical analysts use the price chart indicators to predict the price trends of the EURUSD or any other country’s currency pair. Just like currency traders, stock investors can employ screeners to define the most promising assets and profitable investments.

You don’t necessarily need to use the paid service simplywall.st. There are many free stock screeners. I will present the top stock screeners below:

Finviz

The Finviz screener is popular among investors. It has many filters, it is easy to custom, and it has a free version. The service analyzes the performance of thousands of companies from all over the world, including those, which are not famous among Forex traders.

Yahoo! Finance

It is another tool that will be useful in fundamental analysis of the Forex market and the stock market. Yahoo! Finance is the provider of financial information. In addition to the stock screener and fundamental stock analysis.

It provides a lot of useful information about various financial instruments such as forex markets. You will find the country’s currency quotes, securities rankings, financial and economic reports of companies, press releases.

Criticisms of Fundamental Analysis pros and cons. Disadvantages of Fundamental Analysis.

Fundamental analysis in Forex trading helps investors gather financial information essential to understand current market trends and estimate the potential price growth. Fundamental analysis is useful to make long-term forecasts and evaluate the prospects of an asset. Unlike technical analysis, forex fundamental analysis can’t be used to detail optimal entry points to open positions.

The major flaw is the absence of exact facts and figures. Whatever methods of fundamental study you employ, you will have only general assumptions as an output. Technical analysis tools, conversely, often operate with exact numbers.

Conclusion

Considering the pros and cons of fundamental analysis, professional traders often combine several approaches to studying forex markets. Fundamental factors are used to estimate the prospects. Technical indicators serve to define good points to enter and exit trades. A combined technique lowers the risks as it takes into account a more comprehensive range of factors.

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