ForexFundamental Analysis:ForexFundamental Analysis is a method of analysing the underlying reasons for the value of a stock, currency, commodity, bond, property or other financial asset. Analysts seek to ascertain the intrinsic value of the asset. If it does not match the current market price they can make a forecast based on this information. Technical analysis lies on the other end of the spectrum. It studies price action and uses chart patterns to make forecasts of the future price direction of an asset. Some investors use pure Forexfundamental analysis and some use pure technical analysts. Many use a combination of both.
Macroeconomics is the study of the economy as a whole, the bigger picture. Macroeconomics includes factors such as unemployment rates, gross domestic product (GDP), inflation, exchange rates, interest rates, income levels and consumption levels. Investors in bonds, currencies and commodities will be concerned with trends in the national, regional and global economy. Stock investors are interested in macroeconomic factors but are also concerned with microeconomic factors. Microeconomics looks at the smaller picture including how individual businesses make decisions.
This article is a brief
introduction to Forexfundamental analysis as it might be applied to investing in
stocks. Different approaches to investing will also be outlined including portfolio investing, value investing, growth investing and income
Top Down versus Bottom Up Approach
An investor may adopt a top down approach to finding companies worth investing in. First they would look at the overall economy. Companies will likely do better in a growing economy so that is the starting point. Within that they will search for industry groups that are performing well. For example, the technology sector may be out-performing the health sector. Within that sector they then compare companies to identify which ones have the best prospects. Factors they might consider include the size of their market share, competitive advantages, financial ratios, innovation, management and business plan. Based on this information they are in a better position to identify specific companies with the best prospects.
The bottom up approach works in reverse. Less emphasis is placed on the broader industry. It begins with an analysis of specific stocks. It is possible for a company to perform well even if their industry sector is not the best performing sector in the economy. An investor may be interested in the products and services of a company. In order to ascertain whether they are worth investing in they will start with an analysis of that company.
Quantitative v Qualitative Factors
Quantitative and qualitative factors are also important to consider in Forexfundamental analysis. Quantitative analysis involves anything that can be measured. Factors include profits, sales levels, cash flow, margins, debt levels, wage costs, capital assets, share price etc. Investors will analyse the financial statements of a company to ascertain their financial health. The two principal financial statements are the Profit and Loss account and the Balance Sheet. The Profit and Loss account is a record of income generated and expenditure incurred over a specific period of time. The Balance Sheet is a list of all assets owned and liabilities owed by a company. Financial ratios are vital in Forexfundamental analysis and are widely used by analysts. They can help to identify whether a company will meet its financial obligations. Is it overleveraged? Are there potential liquidity problems?
There is a long list of financial ratios that can be employed by analysts. Some ratios only make sense when used in comparison with similar companies in a sector. Below are some of the more popular ratios.
Liquidity Ratios are a measure of a company’s ability to cover its short term financial obligations. Can they pay the bills, the interest on any debt, etc.?
Current ratio measures whether a company has enough assets to pay its current debts. Investors like to see a ratio above 1.
Acid Test or Quick Ratio is similar to the current ratio but it excludes the inventory of a company. Some companies may not be able to convert inventory to cash as easily as other assets. It is a more rigorous assessment of a company’s ability to pay its current liabilities.
Leverage Ratios measures how a company finances itself. High debt levels can put a company at risk of insolvency. Any downturn in sales, even if only temporary, could result in an inability to pay the debt. They may also find it difficult to raise further finance. Debt financing is a balancing act. Some companies who are well capitalised may be in a position to benefit from taking on more debt.
Profitability Analysis Ratios measure the profitability of a company. A higher result is better because the company is generating more profits from its assets.
ROA measures how profitable a company is relative to its assets.
Return on Common Equity (ROCE) measures the profitability of a company relative to the capital employed. Capital employed is the total of shareholders equity and long term finance. Since it includes long term finance it is more comprehensive than ROA alone. Once again a higher value indicates the company is generating more profit per dollar than a competitor with a lower value.
Profit Margin measures the number of dollars of after-tax profit a firm generates per euro or dollar of sales. A company that makes 10c for every $1.00 of sales revenue has a 10% profit margin.
Earnings per Share (EPS) measures how much of a company’s earnings net of taxes and preferred stock dividends is allocated to each common share. To calculate EPS divide the net income by the number of shares outstanding. For example, a company earns $2,000,000 in the fourth quarter. There are 10,000,000 shares outstanding so EPS = 20 cent. Earnings per share are typically announced on a quarterly basis.
Capital Market Analysis Ratios a measure of a company’s performance on the capital markets. Capital markets are where financial securities such as stocks are traded and issued to raise finance
Price Earnings (P/E) Ratio is
the ratio of the share price of a stock and the earnings per share and is a popular ratio inForexfundamental analysis.
If the EPS of a company is $2 and the stock price is $50 then the P/E = 25. It is not particularly relevant as a figure on its own. Analysts typically compare the P/E of a company with other companies in the same sector or against the company’s own historical P/E. Some use it to calculate the future earnings of a company. Investors interpret a high P/E ratio as meaning future growth. P/E tends to average around 20 to 25 times earnings. It can also show how much investors are willing to pay per dollar of earnings. In the previous example, investors are willing to pay $25 for every dollar of earnings.
Dividend Yield measures what an investor earns in the form of dividends.
If the company’s share price is too high the dividend yield may not be attractive to investors. On the other hand two companies with the same share price will likely have different dividend yields. Take two stocks trading at $20. One pays a dividend of $1 (yield of 5%) while the other pays $2 (yield of 10%).
Financial ratios are used to dig deep into the financial statements of a company. They can yield valuable information by comparing them on a year to year basis and with competitors within the same industry sector.
Qualitative Forexfundamental analysis focuses on less tangible factors that are difficult to measure. What is the quality of the management? What is their track record? What is the business model? How does the company work? How strong is the brand? Have the company got a competitive edge? Is the company transparent? Qualitative analysis can help the investor decide whether they are buying into a quality company.
ForexFundamental Analysis is time consuming and doesn’t provide any guarantees. Markets are a combination of economics and sentiment even the most diligent analyst can be wrong. However, Forexfundamental analysis should help the investor make a better and more informed decision about where to put their money. Analysts should be able to identify a handful of companies that fit their investment strategy. Furthermore, it’s not all about identifying safe companies. Some companies may be a riskier investment but have greater potential for growth. The analyst tries to bring all the data together to make a reasonable judgement about future performance.
In conclusion, Forexfundamental analysis is more suitable for long term investing. A short term trader is more likely to use technical analysis because it is more suitable for that time frame. However, fundamental analysts may use charts as well although they may be based on a longer time frame. By investing for the long term the investor has fewer decisions to make and is less bothered by short term market volatility. Finding value in companies is probably one of the best ways to make money over time. Legendary investor Warren Buffet doesn’t get caught up in the day to day movements of markets. Berkshire Hathaway, the investment company he founded, is a strong proponent of value investing. It averaged an annual growth in book value of 20.3% to its shareholders for the last 44 years. Not bad!