When it comes to trading-whether you're dealing in century-old stocks or emerging cryptocurrencies-there are no clear-cut algorithms to follow. Even if there are, Wall Street's best 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, we can divide these techniques into two categories: fundamental analysis (FA) and technical analysis (TA).
In this article we will cover 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 developing the best strategy that is more likely to produce good returns.
For example, if you have expressed interest in a company, to understand its financial situation, first examine various data such as earnings, 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 makes up the competition? What is the company's target audience? Is its reach expanding? You can zoom out even further to consider 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 of interest and work your way up to understand its place in the overall economy. But you can also apply a top-down analysis, where you narrow down your choices by looking at the big picture first.
The ultimate goal of such an analysis is to calculate the expected price of the stock and compare it to the current price. If the expected price is higher than the current price, you can conclude that the stock is undervalued. If it is lower than the market price, you can assume that it is now overvalued. Based on the results of your analysis, you can make informed decisions to buy or sell a particular company's stock.
Popular Indicators in Fundamental Analysis
To understand fundamental analysis, we won't look at candlesticks, MACD, and RSI; instead, we'll 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 (earnings per share) is a set indicator of a company's profitability, showing how much profit it makes from each share issued. It is calculated using the following formula:
(net income - dividends on preferred shares) / number of shares
Suppose a company pays no dividends and its profit is $1 million. If 200,000 shares are issued, then according to the formula, our earnings per share would be $5. The calculation is not complicated, but it gives us some idea of the potential investment. Companies with higher (or growing) EPS are usually more attractive to investors.
As with the rest of the metrics, EPS should not be the only indicator used to evaluate proposed investments. Nevertheless, it is a handy 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 earnings per share. It is calculated using the following formula:
share price / earnings per share
Let's go back to the company from the previous example, which had earnings per share of $5. Let's assume that each share trades at $10, which gives us a P/E ratio of 2. What does that mean? A lot depends on the other metrics and context.
Often, the price/earnings ratio is used to determine whether a stock is overvalued (if the ratio is high) or undervalued (if the ratio is low). It should be taken into account by comparing it 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 value ratio (P/B)
The price to book value ratio (also known as the price to equity ratio or P/B ratio) tells how investors value a company relative to its book value. Book value is the value of a business as determined by its financial statements (usually assets minus liabilities). The calculation formula is as follows:
earnings per share / book value per share
Again, let's return to the company from the previous examples. Assume that its book value is $500,000. Each share is worth $10, and 200,000 shares are issued. Thus, the book value counts as $500,000 / $200,000, which is $2.5.
If we substitute the numbers into the formula, $10 divided by 2.5 will give us a P/B of 4. At first glance, that doesn't seem too good. The ratio tells us that the stock is currently trading at four times the actual value of the company's stock. This could mean that the market is overvaluing the business, perhaps expecting tremendous growth. If we got a P/B ratio < 1, it would indicate that the market is valuing the company lower than it is actually worth.
A limitation of the applicability of the price to book value ratio is that this ratio is better suited for valuing businesses with large amounts of assets. It turns out that companies with little physical assets are biased in the market.
Price/Earnings to Growth Ratio (PEG)
The price-to-earnings-growth ratio (PEG) is an indicator that complements the price-to-earnings ratio by taking into account the potential growth rate of the asset. It is calculated using the following formula:
price-to-earnings ratio / expected earnings growth per share
Expected earnings growth is an estimate of a company's projected earnings growth over a specified time frame. It is expressed as a percentage. Suppose that for the next five years we estimate the average growth of the above-mentioned company at 10%. Let's take the price/profit ratio (2) and divide it by 10, and the result will be a ratio of 0.2.
This ratio suggests that the investment in the company is profitable because it is severely undervalued given future growth. Generally speaking, any business with a ratio of less than 1 is undervalued. All values higher than that can indicate overvaluation.
The PEG ratio is considered preferable to the P/E ratio because it takes into account a rather important variable that is not inherent in P/E.
Fundamental analysis and cryptocurrencies
The aforementioned metrics 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 the 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:
capitalization / daily transaction volume.
The NVT determines the value of a network based on the volume of transactions it processes. Suppose 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 it is 100. Generally, assets with lower NVT ratios are considered undervalued and assets with higher ratios are considered overvalued. If we consider only NVT, we can conclude that Coin A is undervalued compared to Coin B.
Price to breakeven ratio (P/B)
The price-to-mining breakeven ratio is a measure of the valuation of coins mined by network participants in Proof of Work blockchains. It takes into account the costs of mining, namely the costs of electricity and equipment.
The market price of an asset / the cost of mining one coin
The ratio of price to breakeven level can tell a lot about the current state of the blockchain network. Breakeven 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.
Suppose coin A trades at $5,000 and coin B trades at $20,000, and both have a break-even point of $10,000. The P/E ratio for coin A would be 0.5 and the ratio for coin B would be 2. A coefficient for Coin A of less than 1 means that the 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 make $20,000.
Because of external incentives, you can expect the ratio to tend to 1 over time. As for Coin A, if the price doesn't go up, unprofitable miners are likely to leave the network. Coin B has a higher reward, so we can assume it will be mined more until it is no longer profitable.
The effectiveness of this metric is debatable. Nevertheless, it gives you an idea of the economics of mining that you can consider in your overall evaluation of a digital asset.
Whitepaper, team, roadmap
The most popular method of determining the value of cryptocurrencies and tokens includes also classic methods of project analysis. By studying the whitepaper, you will understand the project's goals, use cases, and technology. A list of team members' accomplishments will give you an idea of their ability to create and scale the product. Finally, by examining the roadmap, you'll understand if the project is on track. These methods can be supplemented with analysis to determine the likelihood that the project will achieve its goals.
Advantages and disadvantages of fundamental analysis
Advantages of Fundamental Analysis
Fundamental analysis is a solid business valuation methodology that technical analysis simply cannot compete with. The study of a number of qualitative and quantitative factors is an important starting point for investors all over the world.
Fundamental analysis can be done by any trader or investor, as it relies on proven methods and available business data. At least, that is the case in traditional markets. In fact, if we look at cryptocurrency (still a small industry), data is not always available, and the strong correlation between assets means that FA may not be as effective.
When done correctly, it provides a basis for identifying stocks that are now undervalued but will rise in value further. Leading investors, such as Warren Buffett and Benjamin Graham, have consistently proven by example that thorough business research using such methods yields terrific results.
Disadvantages of Fundamental Analysis
Fundamental analysis is easy, good fundamental analysis is harder. Determining the "intrinsic value" of a stock is a time consuming process, requiring much more work than simply putting numbers into a formula. A large number of factors need to be evaluated. 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 can remain irrational longer than you will be solvent.
Stocks that seem undervalued (by all measures) will not necessarily rise in the future.
Summary
Fundamental analysis is a well-established practice followed by some of the most successful traders. By refining the strategy, investors can not only learn to better assess the true value of stocks, cryptocurrencies and other assets, but also gain a deeper understanding of the business and the industry as a whole.
Combined with technical analysis, fundamental analysis gives traders and investors a comprehensive view 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 studying emerging cryptocurrency markets, you must understand that FA may not be as effective there. Always do your own analysis and make sure you follow a solid risk management strategy.
Keep your nose to the wind and know that Fortune, Luck and Success
will always favor you,
when you are with us!
Always yours C.J.
All the above is not a financial advice, but only a subjective opinion of the author. If you doubt something, do your own research and double-check the information yourself.
