There is no science to trading whether you are dealing with centuries-old stocks or new cryptocurrencies. Wall Street’s top players make sure that the secret formula is kept a secret even if it exists.
We have many tools and methods that investors and traders can use instead. These methods can be divided into two groups: fundamental analysis and technological analysis.
This article will cover the fundamentals of fundamental analysis.
What is fundamental analysis?
Investors and traders use fundamental analysis to determine the intrinsic worth of businesses or assets. They will examine both internal and external factors in order to accurately evaluate them. These findings will help you to formulate a strategy that is more likely make good profits.
To understand the financial health of a company, for example, you might first examine its earnings, balance sheet, and cash flow. Next, you can zoom in on the company’s size and examine the industry or market it operates. What are your competition? Which demographics does the company target? Are they expanding their reach? You can also scale down. You can scale down even further by taking into consideration economic considerations like inflation and interest rates.
The bottom-up approach is the one you use. You start with the company that interests you and work your way up to learn more about the economy. You can also use a top down approach, which narrows down your options by looking at the larger picture.
This type of analysis aims to determine the expected stock price and compare it with the current price. It can be concluded that the stock is undervalued if the number is greater than the current price. If the number is lower than the market, it can be ruled out that it is overvalued. Using your analysis data, it is possible to make informed decisions regarding whether or not you want to purchase shares in that company.
Fundamental Analysis (FA), vs. Technical Analysis (TA).
Investors and traders who don’t know much about cryptocurrency, forex, or stock market trading often don’t know which approach to choose. Both technical and fundamental analysis are very different and use different methods to analyze different things. Both provide trade-relevant data. Which one is better?
It would be smarter to ask each one what they bring to the table. Fundamental analysts believe that a stock’s price doesn’t necessarily reflect its true value. It is the ideology behind their investment decisions.
Technical analysts, on the other hand, believe that price movements in the future can partly be predicted based upon past volume and price data. Technical analysts do not focus on external factors. Instead, they look at price charts, patterns, and trends in the markets. They seek to determine the best entry and exit points for positions.
The Efficient Market Hypothesis (EMH), which is supported by technical analysis (TA), argues that it is impossible for a market to keep pace with technical analysis (TA). This theory holds that financial markets are all information available about assets and take into consideration historical data. EMH weaker forms do not discredit fundamental analyses, but EMH weaker forms do discredit fundamental analytics. However, weaker forms of EMH claim that it is impossible to gain competitive advantage even with meticulous research.
There is no better strategy than a pair. Both can offer valuable information in different areas. While some trading styles may be more suited for certain types of traders, most traders combine both to get the larger picture. This applies to both short-term and long-term investments.
Indicators that are popular in fundamental analysis
To understand fundamental analysis we don’t use candlesticks, MACDs, or RSIs. Instead, we use several FA-specific indicators. We will be discussing some of the most well-known indicators in this section.
Earnings per Share (EPS)
The company’s profitability is measured by its earnings per share. This shows how much it makes from each stock outstanding. The following formula is used to calculate it:
(net profit - dividends on preferred shares) / number of shares
Imagine a company that does not pay dividends and has a profit of $ 1,000,000 The formula yields earnings per share of $5 when we issue 200,000 shares. Although the calculation is not complicated, it can provide some insight into potential investment. Investors are more attracted to companies with growing (or higher) earnings per share.
Some prefer diluted earnings for each share because it takes into consideration factors that could increase the number of shares. Employees have the option to buy shares of the company through stock options. This typically results in more shares to split the net income so we expect to see lower diluted earnings per stock than simple earnings.
Earnings per share, like all indicators should not be used as the sole metric to determine a perceived investment. It can be useful when combined with other indicators.
Price-to-earnings ratio (P/E)
The price-to earnings ratio, or simply P/E ratio, is a ratio that compares the stock price with its earnings per share. The following formula is used to calculate it:
share price / earnings per share
Let’s use the same company as the previous example. It had earnings per share $5. Let’s assume that each stock trades at $10. This gives us a P/E ratio 2. What does this mean? It all depends on the results of the rest.
The profit-to-earnings ratio is often used to determine if a stock’s value is too high or low. This number should be compared to similar businesses to determine if it is worth considering. This rule is not always adhered to, so it should be used with other methods of qualitative and quantitative analysis.
Price-to-book value ratio (P/B)
The price-to book value ratio, also known as the P/B ratio or price-to equity ratio, can be used to determine how investors value a company relative to its book value. The book value is the business’s value as defined by its financial statements (usually assets less liabilities). This is how the calculation looks:
price per share / book value per share
Let’s return to the company we saw in the previous examples. Let’s say that the company has a book value of $500,000. Each share is $ 10 and there are 200,000. Our book value per share is $500,000 multiplied by $200,000 to get $2.5.
If we add the numbers to the formula, $10 divided with $2.5 will give us a price/book value ratio of 4. This doesn’t seem like a good deal at first glance. This means that stocks trade at four times the price of what the company actually is worth. This could indicate that the market is expecting great growth and overvaluing the company. A ratio lower than 1 would mean that the business is worth more than what the market recognizes.
Limitations of the price-to book value ratio are that it is not suitable for valuing large assets. Companies with limited physical assets are often not represented.
The price/earnings-to-growth ratio (PEG) is an extension of the profit-to-earnings ratio, expanding its range given the growth rate. The following formula is used:
price-to-earnings ratio / profit growth rate
The profit growth rate represents the expected growth in profits over a given time period. This is expressed as a percentage. Let’s say we estimate the average growth rate of the aforementioned company at 10% over five years. To get a ratio of 0.2, we take the price-to profit ratio (2) and divide it with 10.
This ratio indicates that the company is a good business investment because it is grossly undervalued in light of future growth. A business with a ratio lower than 1 is generally considered undervalued. All of the above are possible to be overrated.
People prefer the PEG to the P/E ratio, as it considers a very important variable that the P/E doesn’t.
Cryptocurrencies and Fundamental Analysis
These indicators do not apply to cryptocurrency. To assess whether a project is viable, you should look at other factors. This section outlines several indicators that cryptocurrency traders use.
Network cost-to-transaction ratio (NVT)
It is commonly referred to as the P/E ratio for cryptocurrency markets. However, it is fast becoming a standard in crypto-FA. You can calculate it as follows:
network cost / daily transaction volume
NVT uses transaction data to determine the value of a network. Let’s take two projects, Coin A and Coin B. Both projects have a market capitalization of $1,000,000. Coin A has a daily transaction volume of $50,000 while Coin B is worth $10,000.
The NVT ratio of A coins is 20 while the NVT for Bis coins is 100. Assets with a lower NVT rate are generally considered undervalued. However, assets with higher odds of success can be considered overvalued. These merits alone indicate that coin A is less valuable than coin B.
To gauge the extent of their use, some look at the active addresses in the network. It is not a reliable indicator of network activity, but it can still be useful. This can be used to calculate the true value of this digital asset.
For Proof of Work coins, the price-to-break even ratio of mining can be used as an indicator to evaluate their value. It is used by network participants to determine how Proof of Work coins are being mined. This includes the cost of electricity, equipment, and other costs.
rynochnaia-tsena Monety / Stoimost' Dobychi Monety
The ratio between price and break-even mining can reveal a lot about the state of the blockchain network. Break-even is the cost of producing coins. If it is $10,000 then miners typically spend $10,000 to make a new unit.
Let’s say that Coin Atrades are $5,000 and Coin Bat $20,000 respectively, with a break-even of $10,000. Coin As will be 0.5, and Coin Bs 2 The Coin As ratio will be 0.5 and Coin Bs will be 2. This means that miners are making a loss when compared to coin mining. MiningCoinBis makes mining profitable because you can expect to make $20,000.
The incentives would lead to the ratio increasing to 1. If the price doesn’t rise, miners who make a loss on Coin A are more likely to leave the network. Coin B offers a great reward so it’s reasonable to expect that more miners will join it until it ceases making profits.
It is not clear if this indicator is effective. It does give you an idea about the economics behind mining that you can use when you evaluate a digital asset.
White Paper, Team, and Roadmap
Research on the project is the best way to determine the value of cryptocurrency and tokens. The white paper will help you understand the project’s goals, use cases, and technology. You can see the track record of each team member to gain insight into their ability build and scale products. The roadmap also tells you whether the project is on track. You can add additional studies to help determine the likelihood of the project reaching its main stages.
Fundamental Analysis: The Pros and the Cons
The Pros and Cons of Fundamental Analysis
Fundamental analysis is more robust than technical analysis in business valuation. Investors around the globe need to understand a variety of quantitative and qualitative factors before making any trade.
Fundamental analysis can be done by anyone, provided it uses proven methods and has access to business data. This is the case for traditional markets at least. Cryptocurrency, which is still a small industry, has data that isn’t always readily available. The strong correlation between assets also means that FA might not be as efficient.
It can be used to identify stocks that are undervalued or that will increase in value over time if done correctly. Warren Buffett and Benjamin Graham, two of the most successful investors in the world, have repeatedly demonstrated that this method can produce amazing results.
Cons of fundamental analysis
It is simple to perform fundamental analysis, but more difficult to do a good one. It is more complicated than simply adding numbers to a formula to determine the intrinsic value of a stock. It is difficult to evaluate many factors and it can take a lot of time to learn how to do this correctly. It is also better suited to long-term transactions than short-term ones.
This analysis fails to recognize the strong market forces and trends that technical analysis is able to identify. John Maynard Keynes, an economist once stated:
You can’t let the market remain rational longer than you can stay solvent.
Stocks that appear undervalued by all accounts are not guaranteed to increase in value in future.
Some of the most successful traders use fundamental analysis. Investors can refine their strategy to not only better determine the true value of cryptocurrencies or stocks, but also gain a greater understanding of business and industry in general.
Fundamental analysis, when combined with technical analysis gives investors and traders a complete view of which assets and businesses are most profitable. Many in traditional and crypto markets welcome the combination of FA/TA.
The rise of cryptocurrency markets means that the FA might not be as effective. Always do your research and ensure you have a sound risk management strategy.