Introduction
When it comes to trading—whether you're dealing in century-old stocks or emerging cryptocurrencies—there are no clear rules of thumb. Even if they do, Wall Street's top players ensure that the formula for success remains a secret.
Instead, we have a wide range of tools and methodologies used by traders and investors. In general, these methods can be divided into two categories: fundamental analysis (FA) and technical analysis (TA).
In this article we will look at the basics of fundamental analysis.
What is fundamental analysis?
Fundamental analysis is a method used by investors and traders to determine the intrinsic value of an asset or business. To accurately estimate this value, they carefully examine internal and external factors and determine whether the asset or business in question is overvalued or undervalued. These results will help in coming up with the best strategy that is more likely to generate good profits.
For example, if you have expressed an interest in a company, then to understand its financial position, first study various data such as profits, balance sheets, financial statements and cash flows. Then look at the bigger picture to examine the market or industry in which the company operates. Who is the competition? What is the company's target audience? Is coverage expanding? You can zoom out even further to take into account general economic factors such as interest rates and inflation, to name just a couple of factors.
The steps described above are called bottom-up analysis: you start with the company you're interested in and work your way up to understand its place in the economy as a whole. But you can also use top-down analysis, where you narrow down your choices by first looking at the big picture.
The ultimate goal of this analysis is to calculate the expected price of the stock and compare it with the current price. If the expected price is higher than the current price, we can conclude that the stock is undervalued. If it is below market value, then we can assume that it is now overvalued. Based on the results of your analysis, you can make informed decisions about buying or selling shares of a particular company.
Fundamental Analysis (FA) vs Technical Analysis (TA)
New traders and investors with little knowledge of cryptocurrency, forex or stock markets are often confused about which approach to take. Fundamental analysis and technical analysis are very different from each other and rely on fundamentally different methodologies. Yet both provide data relevant to trading. So which one is better?
Generally speaking, it's worth figuring out what exactly each of these approaches does. The main idea of fundamental analysis underlying investment decisions is that the price of shares does not necessarily indicate their true value.
In contrast, according to the idea of technical analysis, price movements can be predicted based on past price and volume data. Technical analysis does not look at external factors, instead focusing on price charts, patterns and trends in the market. The task of technical analysis is to determine ideal points for entry and exit from positions.
Proponents of the Efficient Market Hypothesis (EMH) believe that it is impossible to consistently outperform the market using technical analysis (TA). This hypothesis assumes that financial markets provide all known information about assets (that they are “rational”) and that they already take historical data into account. “Weaker” interpretations of EMH do not discredit fundamental analysis, but “stronger” ones argue that even with careful analysis it is impossible to gain a competitive advantage.
It is clear that of these two strategies there is no objectively better strategy, since both can provide valuable information on different aspects. Some trading styles have their own strategy, and in practice many traders combine them to form a broader view of the market. This is true for both short-term transactions and long-term investments.
Popular indicators in fundamental analysis
To understand fundamental analysis, we will not look at candlesticks, MACD and RSI, but instead look at FA-specific indicators. In this section we will discuss a few of the most popular ones.
Earnings per share (EPS)
Earnings per share is an established indicator of a company's profitability, showing how much profit it generates from each share issued. It is calculated using the following formula:
(net profit - dividends on preferred shares) / number of sharesLet's say a company doesn't pay dividends and its earnings are $1 million. If 200,000 shares are issued, then the formula tells us our earnings per share will be $5. The calculation is simple, but gives us some idea of the potential investment. Companies with higher (or growing) EPS are usually more attractive to investors.
Some investors prefer diluted earnings per share because it takes into account factors that increase the total number of shares. For example, with stock options, employees are given the opportunity to purchase shares of the company. Because this means more shares to share in net income, diluted EPS is lower than simple EPS.
As with all metrics, earnings per share should not be the only indicator used to evaluate a proposed investment. However, it is a convenient ratio when used in conjunction with others.
Price/earnings ratio (P/E)
The price-to-earnings ratio (or P/E ratio) evaluates a business by comparing the share price to the earnings per share. It is calculated using the following formula:
share price/earnings per shareLet's go back to the company from the previous example, which had earnings per share of $5. Let's say each share is trading at $10, giving us a P/E ratio of 2. What does this mean? Much depends on other indicators and context.
Often, the P/E ratio is used to determine whether a stock is overvalued (if the ratio is high) or undervalued (if the ratio is low). It must be taken into account when compared to the P/E ratio of similar companies. Again, conclusions based on the P/E ratio alone are not always correct, so it should be used in conjunction with other quantitative and qualitative analysis methods.
Price/Book Ratio (P/B)
The price-to-book ratio (also known as the price-to-equity ratio or P/B ratio) tells how investors value a company in relation to its book value. Book value is the value of a business as determined in its financial statements (usually assets minus liabilities). The calculation formula is as follows:
earnings per share / book value per shareLet's go back to the company from the previous examples. Let's assume its book value is $500,000. Each share is worth $10, with 200,000 shares issued. Therefore, the book value is calculated as $500,000 / $200,000, namely $2.5.
If we plug the numbers into the formula, $10 divided by 2.5 gives us a P/B of 4. At first glance, this doesn't look too good. The ratio tells us that the stock is currently trading at four times the company's actual share price. This could mean the market is overvaluing the business, perhaps expecting huge growth. If we were to get a P/B ratio < 1, it would indicate that the market values the company lower than it is actually worth.
A limitation of the applicability of the price-to-book ratio is that it is better suited for valuing businesses with large amounts of assets. It turns out that companies with a small volume of physical assets are not objectively represented on the market.
Price/Earnings to Growth (PEG) Ratio
The price-to-earnings-to-growth (PEG) ratio is a metric that complements the price-to-earnings ratio by taking into account the potential growth rate of an asset. It is calculated using the following formula:
P/E ratio/expected EPS growthExpected earnings growth is an estimate of a company's projected earnings growth within a specified time frame. It is expressed as a percentage. Let's say that over the next five years we estimate the average growth of the above-mentioned company to be 10%. Take the price/earnings ratio (2) and divide it by 10, resulting in a ratio of 0.2.
This ratio suggests that the company is a profitable investment because it is highly undervalued based on future growth. Generally speaking, any business with a ratio less than 1 is undervalued. All values above may indicate overvaluation.
The PEG ratio is considered preferable to the P/E ratio because it takes into account a fairly important variable that is not included in the P/E ratio.
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Fundamental analysis and cryptocurrencies
The above indicators do not apply to cryptocurrency. Instead, other ratios are considered to assess the viability of a project. This section presents several such indicators used by cryptocurrency traders.
Network Value to Transaction Volume (NVT) Ratio
In cryptocurrency markets, the equivalent of the P/E ratio is the NVT ratio - the main indicator for FA in cryptocurrencies. It is calculated as follows:
network value / daily transaction volumeNVT determines the value of a network based on the volume of transactions it processes. Let's say you have two projects: Coin A and Coin B. Both have a market capitalization of $1,000,000. However, the daily transaction volume for Coin A is $50,000 and for Coin B is $10,000.
The NVT ratio for Coin A is 20, and for Coin B is 100. Generally, assets with lower NVT ratios are considered undervalued, while assets with higher ratios are considered overvalued. If we consider only NVT, we can conclude that Coin A is undervalued compared to Coin B.
Active addresses
It makes sense to limit the number of active addresses in the network to assess how much it is used. Although this metric is unreliable as a standalone indicator (the metric can be easily manipulated), it can still provide information about online activity. You can take it into account when comprehensively assessing a digital asset.
Price to breakeven ratio
The ratio of price to mining breakeven is an indicator of the valuation of coins that are mined by network participants in Proof of Work algorithm blockchains. It takes into account the costs of mining, namely the costs of electricity and equipment.
market price of an asset / cost of mining one coinThe price to break-even ratio can tell a lot about the current state of the blockchain network. Break-even refers to the cost of mining one coin - for example, if the cost of mining is $10,000, then miners spend $10,000 to mine a unit of the asset.
Let's say Coin A is trading at $5,000 and Coin B is trading at $20,000, and both have a break-even point of $10,000. The P/BE coefficient for coin A will be 0.5, for coin B – 2. The coefficient for coin A is less than 1, which means that miners are working at a loss. In contrast, mining Coin B is profitable because for every $10,000 you spend on mining, you expect to receive $20,000.
Due to external incentives, you can expect the ratio to tend toward 1 over time. As for coin A, unless the price goes up, unprofitable miners will likely leave the network. Coin B has a higher reward, so it can be assumed that it will be mined more until it stops being profitable.
The effectiveness of this indicator is controversial. However, it does give you an idea of the economics of mining that you can factor into your overall assessment of a digital asset.
Whitepaper, team, roadmap
The most popular method of determining the value of cryptocurrencies and tokens also includes classical methods of project analysis. By reading the whitepaper, you will understand the project's goals, use cases, and technologies. A list of team members' accomplishments will give you an idea of their ability to build and scale a product. Finally, by reviewing the roadmap, you will know if the project is going according to plan. These methods can be complemented by analysis to determine the likelihood of a project achieving its goals.
Advantages and disadvantages of fundamental analysis
Advantages of fundamental analysis
Fundamental analysis is a reliable business valuation methodology that technical analysis simply cannot compete with. Understanding a range of qualitative and quantitative factors is an important starting point for investors around the world when making transactions.
Fundamental analysis can be performed by any trader or investor because it relies on proven methods and available business data. At least this is the case in traditional markets. Indeed, if we look at cryptocurrency (still a small industry), data is not always available and the strong correlation between assets means FA may not be as effective.
When done correctly, it provides a basis for identifying stocks that are currently undervalued but will continue to rise in value. Leading investors such as Warren Buffett and Benjamin Graham consistently demonstrate that rigorous business research using these methods produces amazing results.
Disadvantages of Fundamental Analysis
Fundamental analysis is easy to do, but good fundamental analysis is more difficult. Determining the “intrinsic value” of a stock is a time-consuming process that requires much more work than simply plugging numbers into a formula. There are a large number of factors to evaluate, and the learning curve to do this effectively can be steep. In addition, fundamental analysis is more suitable for long-term trades than short-term ones.
This type of analysis also does not take into account the powerful market forces and trends that technical analysis can identify. As economist John Maynard Keynes once said:
The market may remain irrational longer than you will be solvent.
Stocks that appear to be undervalued (by any measure) are not necessarily expected to rise in the future.
Conclusion
Fundamental analysis is an established practice that is followed by even the most successful traders. By refining their strategy, investors can not only better assess the true value of stocks, cryptocurrencies and other assets, but also gain a deeper understanding of businesses and industries as a whole.
When combined with technical analysis, fundamental analysis gives traders and investors a comprehensive understanding of which assets and companies are profitable. The combination of FA and TA has proven itself by many in both traditional and cryptocurrency markets.
However, when exploring emerging cryptocurrency markets, you should understand that FA may not be as effective in them. Always do your own research and ensure you are following a sound risk management strategy.