The Fundamental Analysis is the other great pillar used in the investment world, being the other the Technical Analysis.
This type of analysis is carried out on the economic data reported by companies and the world’s economies, whether they are: profits, assets, debts, employment and unemployment data, trade deficit, inflation, et cetera.
Why is this study carried out on the data and results of the economic agents?
Obvious: to try to make predictions of the future economic performance; Predictions that aim to make money to economic agents dedicated to the fascinating world of investment.
Therefore, with fundamental analysis we try to discover when those moments are worth buying or selling a company and not another. In addition, this is something important between companies in the same sector, or even similar economies.
For example, the general opinion is that the analysis of quantitative data of a company has to be done in comparison with companies in the same sector and that it does not make sense to buy a bank with a mining company.
The theorists of this analysis maintain that the markets have moments in which they do not impute a correct price to an asset, and that it is at those moments, which have to be captured with the studies of ratios and historical data, when it is necessary to buy the assets.
Types of fundamental analysis
We can divide the study of fundamental analysis into several types:
- Private companies
- Business sectors
- Economic analysis of public bodies, such as countries
- Raw Materials
In the first case, with publicly traded companies, we have a large amount of data, ranging from the level of indebtedness, to the profits, to the cash.
As we can understand, it is a world that gives us infinite possibilities.
In the case of business sectors, these are the standard to try to measure companies with the same yardstick, and comparisons between companies in the same sector is the most widely used practice in fundamental stock market analysis.
The analysis of the macroeconomic data of the nations is of great importance, for example for the fundamental analysis of Forex, since with the data that the countries are presenting us, we try to advance what direction the main movement of the currency that we are analyzing will have.
For example, depending on the economic policies of a country and its effect on the money supply, inflation, employment, productivity, and other data, we could determine if the currency of that country is going to depreciate or appreciate with that of another country. In this case, the world reference currency to compare is obviously the dollar.
In raw materials we do not have so much data to analyze, but it is always interesting to know how production data are coming out, and to know perfectly the historical seasonal cycles of prices.
Once we have these agents, we can even face two totally different types of approaches: From “Up down” and “Down up”
With the top-down first is to study the macroeconomic data to go down level, to the sectors, and once having a global vision of how the economy can go, choose the actions of the sectors that are determined as more potential.
In the bottom-up it’s the other way around. We started by studying the companies and determining which ones present the best opportunities in quantitative terms. Then we go to our analysis until we reach the macro results, which will give us the last brushstroke on the decision we have to make.
How is fundamental analysis used?
This will depend on the style of the investors who are in charge of the investment portfolios, whether individuals or organizations are more or less complex.
There are investors who prefer to give importance to buy and hold strategies. With this strategy of buying and maintaining what they are trying to do is find the companies that are financially more undervalued to buy them and keep them as a long-term investment.
Others prefer to invest following the principles of Value, trying to emulate large investors such as Warren Buffet.
Other investors pay much more attention to dividend policies and try to find companies that have the best prospects in this field.
Main ratios for Fundamental Stock Market Analysis
Of all the fundamental analyzes, the most important and known is the Stock Market, which is made on the business results of the shares listed on international markets.
The literature and studies related to this type of analysis are endless and form, together with technical analysis, the basis of the quantitative study of the world of speculation.
Whatever we do, applying fundamental analysis in companies requires eviscerating your business results, both in the financial balance and in the profit and loss account, or memory.
The amount of ratios and formulas that we can apply is very extensive and the limit is only in the human imagination.
Let’s see what some of the best ratios for comparing companies are.
PER or PE ratio
The PE is one of the most used ratios in the world. It measures the price of the action in relation to the profits.
Of course people think that a low PER can indicate that an action is cheap, but that does not always mean that buying in those cases is the best idea.
PE of Shiller or CAPE
It is a mean that softens the previous indicator.
The ROE (return on investment) is one of the favorite indicators of Warren Buffet and it comes to give us a measure of the return on own resources.
This ratio tries to give us a measure between the current market value of the company with respect to the accountant, with the objective of “telling us” if the company is overvalued or not.
As with the rest of the ratios, it is quite subjective, at least its interpretation.
This ratio is very simple and does not require much explanation.
If the price of the share is 100 and it distributes 4 euros per share in this year, the dividend yield is 4% with that title.
This ratio is widely used by many investors at the time of investing, who like companies that pay an important part of the profits on an annual basis.
These ratios, as the name says, try to measure the cash capacity that the company has to face its short-term obligations.
Among the most important ratios of this type we have:
- Ratio of current ratio
- Acidity ratio
- Defensive test ratio
- Average period of collection ratio
- Rotation of accounts receivable
Ratio designed to measure the risk of financial assets and compare them according to the same
There are many other ratios of fundamental analysis, which also do not have to be ratios, but simple important data relative to particular sectors.
Examples of elements that we can use to perform financial analysis are:
- Long-term debt
- Market penetration
- Pageviews (for online companies)
- Sales and purchases of insiders
- Staff costs
As we see, if we want, we can make our financial analysis as complex as we want.
Advantages of the fundamental analysis
It is focused on the long term, with how beneficial that is for the investors’ portfolio. We already know, or should know, that short-term trading is an activity where most traders lose
Done well can give us good results when choosing our future investments
Expand your financial knowledge in a self-taught way
Disadvantages of fundamental analysis
It consumes a lot of time, although with the advent of automation and “Artificial Intelligence” things are changing very quickly in this sense.
It is a subjective model. Experience tells me, and many others, that what is said in the theory does not work perfectly and that in many cases the ratios that are supposed to be good end up giving us very bad choices. This usually happens a lot with companies that end up going bankrupt or failing, because in those cases, just before going into catastrophic losses, they give us ratios that tell us how “cheap they are”.
Subjectivity does not end there.
In fact, that subjectivity is what causes us to get out of the quantitative paradigm and with imagination and study to apply original and new ideas that make us triumph over the rest of the market.
Because there are no magic formulas and simply applying blind purchases at the level x of the ratio y, it will not provide us with a comparative advantage with respect to the long-term market, especially when we speak of periods of 30 or 50 years.
In the short term, even in periods of a decade, some investors obtain more profitability than the market buying x when the ratio is y, and they think they have discovered the Philosopher’s Stone, when the reality is that the long term ends up correcting the practice totality of these situations.
Fundamental analysis trends
In the past the fundamental analysis had a “market share”, to put it that way, or rather a lot more popularity.
This was because 40 years ago most of the world of investment was made by making decisions based on the studies of economic and business accounts, much less on the basis of short-term trading techniques, par excellence by technical analysis.
With time, and the advent of the internet, stock market charts became so popular that every investor in the world has access to them from the armchairs of their homes.
This has meant that “democratization” has led to a radical increase in technical analysis studies, which are used by most private investors in homes, trying to dominate short-term financial charts.
This does not mean that the fundamental analysis has died.
On the contrary, it is still very popular, and it is almost mandatory in the teams of management funds and investment managers of the world.
What is increasing unstoppably in this sector, as in almost all related to information technology, is the massive automation of the same, more and more emerging programs capable of making the most complex studies that we can imagine in a negligible amount of time. Something that previously would cost countless hours of study to the analysts, they can do now with a program of algorithms.
The future seems to provide us with a world of fundamental analysis where machines and Artificial Intelligence are going to have a strong preponderance.
Original article: Análisis fundamental