Every trade starts with an idea. The next stage is to carry out some analysis on it, certainly before you risk any money testing out your theory in the market.
What is fundamental analysis?
Some speculators (primarily day traders) have no interest in fundamentals and instead place their trust in technical analysis. Their argument is that fundamental market influences often take a long time to pan out and so are of little use when you’re only holding a position for only a few hours, if that.
But short-term deals aside, fundamental analysis should be the starting point for any other trade, whether it is on an individual equity, a stock index, commodity, currency pair or bond. Then, once the fundamentals have been studied it’s time to look at charts and employ technical analysis to identify the best entry and exit points for your trade idea.
What is fundamental analysis? In essence it’s pretty much everything that isn’t technical analysis and it differs in scope depending on the type of financial instrument you intend trading. As far as individual equities are concerned you will need to carry out analysis on a specific company, as well as some of its peers. You need to know what the company does, where it operates, who runs it and how financially stable it is. A big multinational may be stable because it is diversified. But this could also mean that growth in one particular division may be offset by a slowdown elsewhere. In contrast, a company that concentrates on a single product may experience stellar growth but then not be protected if something goes wrong in a specific area.
You may want to begin by reviewing the company’s management team. It’s usually enough to concentrate on the top two executive figures – the Chief Executive Officer (CEO) and Chief Financial Officer (CFO) or their equivalents. The chairman/woman and non-executive directors are less important – non-execs don’t drive the business on a day-to-day basis, and the Chair is in many cases little more than a figurehead. We want to “know” about management, but we must be wary of getting too bogged down. Find out how long the two senior officers have held their current positions, how long they’ve been with the company and where they worked before. Also, check out any controversies that may be attached to them, such as concerns over excessive pay packages.
Next we want to look at the financial health of the company. This means looking at the Balance Sheet and the Profit & Loss Account. Such information is freely available via Yahoo Finance, corporate websites or other sources, so in most cases there’s no need to pay out for financial reports. The balance sheet is a snapshot which shows a company’s assets and liabilities at a particular moment in time. This is a measure of a company’s financial health. It shows what the company owns and what it owes and both sides of this ledger must always balance. Hopefully assets exceed liabilities and the balancing item is equity which comes under Total Liabilities.
The most important thing for us to do is to compare the numbers from year to year (this can also be done on a quarterly basis) and watch out for any significant changes. For instance, a sudden jump in net receivables under assets may suggest that a supplier is having difficulty in meeting its obligations to the company. Alternatively, it could mean that the company has increased sales dramatically, maybe by winning a large contract. This is the kind of item that requires further investigation.
The Profit & Loss account shows revenues at the top with expenses in the middle. Take expenses away from revenues and that gives us the overall profit (or loss) the company made over a particular period. We can then compare this with previous years or quarters to give ourselves an idea of how the company has performed over time. As with the balance sheet, we’re on the look-out for any numbers which are out of whack with previous years. But we’re also watching out for trends in the data. Are revenues steady, growing or in decline? What about the direct costs – that is the costs of, say, the raw materials needed to manufacture a product? Are these rising sharply? But even if they are, it may be that revenues are rising faster. How about indirect costs like wages, marketing and the like? All these numbers slot into the P&L account.
It is also worth looking at valuation metrics, not just for the company you’re analysing but also for the sector it operates in. This will help you to see if the company looks expensive or cheap relative to its competitors and the wider market as well. Such metrics are relatively easy to find by searching the websites of data providers such as Reuters and Digital Look. Now it’s important to bear in mind that these numbers are constantly changing as new information comes in, particularly P/E ratios which vary as the share price moves. The P/E ratio is the price per share divided by the earnings per share, so this gives us a quick and easy way of valuing a company against its competitors and the broader market. If a company’s current share price is cheap relative to its earnings then this suggests at least that the stock may be reasonably valued. It’s also worth noting that sometimes this information is out of date or inaccurate and that anomalies are common, so we have to be very careful when considering this type of data.
A high P/E ratio can suggest investors are paying a higher-than-average price for a stock and consequently investors expect higher earnings growth. That's why ratios of more than 20 are considered risky and are usually posted by young, fast-growing companies. Lower ratios are traditionally associated with firms that have low growth or are in older industries, or stocks that are out of favour with investors.
Some companies are popular with investors because they pay out a healthy dividend. This is also something to cover during fundamental analysis. However, it’s worth remembering that corporations can only continue to pay out dividends if they are doing well. A company’s stock price can fall sharply if the dividend outlook deteriorates.
Ultimately the aim is to find companies that have good product streams, or offer unique products with high barriers to entry for competitors. In addition, our fundamental analysis should identify companies that are well-run and financially sound. There’s no doubt that all this investigation takes time and effort. There’s also a good chance that fundamental analysis throws up a stack of reasons not to buy a particular stock. Of course, then it could become a potential shorting opportunity - something that is easy to do with CFDs.
But it’s only once you’re happy with a company’s fundamentals that you turn your attention to technical analysis. This in turn could tell you that the stock is already too overbought to consider buying or is too oversold for you to reasonably sell. If that’s the case then put the stock on a watch list and wait for a better trading opportunity.
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