We can do different types of analysis, the best known is technical analysis, in this article I will describe fundamental analysis in trading and how to apply it to financial markets.
Fundamental analysis is the study of a company’s economic conditions in order to determine stocks’s value. In a few words it helps to understand if a stock is overvalued or undervalued, so a trader will choose whether to open a long/short position, exit the market or wait the best moment.
Fundamental analysis focuses its studies on a company’s statistics, such as the balance sheet, growth prospects and macroeconomic data. If a company makes profits, the investor will decide to bet on the price rise while if the data is negative will have to be careful “if” and “when” to enter the market.
Fundamental analysis focuses its attention on the development of economy and statistical companies’s data, based on 4 elements:
- Define the value of the company’s stock
- Define the health of society
- Defining macroeconomic situation
- Define sector’s state (industry, energy, technology…)
When I do the fundamental analysis I focus on the company’s financial health, for example I check the balance sheets (although they are not always true) and I focus on: leverage, price, profit and liquidity.
After this work I add interest rates, how they are moving, if rates go up people spend less then there will be an economic slowdown, if interest rates fall consumption will be higher and companies will produce more.
A company’s sector is also critical to framing economic environment, as they say in Chicago, weak stocks in a strong sector than in the opposite. Some elements to study to make an accurate analysis are:
- Current Ratio measures the company’s ability to meet current debt obligations.
- Debt Ratio is useful to understand the debt, in case of a negative moment a high value is a bad alarm while in a positive moment the company can get into debt at lower costs.
- P/E Ratio is the earnings price ratio, it is calculated by dividing the share price by earnings (EPS). If Apple odds 300 dollars and the EPS is 3 dollars the result is 100. You, an investor, have to pay 100 dollars for three dollars in income.
- Net Profit Margin is calculated by dividing net revenue by total sales, it is important to understand how much profit the company is able to make for every dollar sold.
Fundamental analysis must help us understand how people’s behaviour affects the market, it complements technical analysis because it will prevent us from investing in troubled sectors or companies with unsatisfactory requirements.
For those who start it may seem difficult, even I at the beginning I missed several numbers then as everything, time and experience allow to improve and automate the process.
I recommend you choose a few companies to analyze and follow them constantly, do not do as some “trader 3.0” who trade on any market and follow too many stocks.