Greetings traders and welcome back.
My name is Chris, and I'll be your host today as we slide
into another Survival Guide.
Today, we're going to be covering the subject of fundamental analysis.
Everyone knows that the accuracy of an investor is going
to determine their success rate, but how they come to that
accuracy is the question. There's technical analysis, and there's
fundamental analysis.
Today, we're going to be focusing on the fundamental side of things.
We're going to explain exactly what that is, as well as some
of the top strategies that we can do when employing fundamental
analysis. Without further ado, let's dive on into it. Here we go.
Fundamental analysis is the most popular method of choice
for investors seeking to gain an edge or some insight into an investment decision
they might be considering and making. But what is fundamental
analysis? By the definition, fundamental analysis is an accounting
and financial methodology that is focused on identifying
key metrics about a particular company and valuing its health
by looking at its financial statements.
To put it simply, the aim of fundamental analysis is to provide
a precise estimation of a particular security's intrinsic
value. The keyword is: Focusing on the intrinsic value.
That's what we're doing with fundamental analysis.
That means that we're using and analyzing all relevant data
to come up with a number that us as investors can compare
with the security's current price to decide whether it's
either undervalued, or perhaps overvalued.
In other words, this means we're trying to give ourself
a solid idea on whether or not we have a good investment
choice because the value of something on the surface is not
matching up with the value of something underneath the surface.
Fundamental analysis has also been around for quite some
time, just like technical analysis. A man by the name of Benjamin
Graham is often referred to as the father of fundamental
analysis. He published a book in 1934 that is still a good read today,
called Security Analysis. That book warns investors against
the dangers of speculative behavior and encourages them to
focus on, them being Traders, it encourages traders to
focus on the intrinsic value of a security.
Fundamental analysis versus technical analysis. Ready, fight!
Just kidding, but between the two of them, what are the differences
that we have going on here?
Well on the fundamental side, we see right off the bat for the function,
it says mostly suitable for investing.
This is referencing the idea that fundamental analysis does
tend to be a favorite for those that are looking for long-term
investing, in terms of stocks et cetera. Things along
those lines. Whereas technical analysis is more common with
traders that are more interested in day trading.
This is obviously just a broad generalization, even though
it is based on some fact, but that is the case.
It does not mean that if you are a fundamental analysis loving
trader, you can't use it to day trade. That's not what we're saying here.
Just the nature of how we analyze the intrinsic
value of something doesn't necessarily help in a short term
asset like trading, say, oil futures. But who are they used
by? Well, with fundamental analysis, we have long-term investors.
This goes back to what we were talking about. Long-term investors
looking to find the intrinsic value of an asset.
Whereas with technical analysis,
we have traders interested in short-term price movements
trying to make gains on a quick break out for example.
The objective is to define whether the asset
is undervalued or overvalued with fundamental analysis.
That's that intrinsic setting that we were talking about,
that intrinsic nature of it. With technical analysis, we're looking to time the
perfect moment for entering or exiting a trade.
It's that more zoomed in style where we're trying to catch
the move right before it happens, instead of invest in something
that we anticipate will continue to climb over the next few years.
The field of application is going to be mostly stocks, but
also works more for bonds, derivatives, as well as other things
in that category as well.
Basically, long-term buy and hold style of trading, right? Swing
trading could be somewhat categorized into this nature,
but realistically, it is even going to be longer than regular swing trading.
It's going to be that long-term investment category that
fundamental analysis works well with, but with technical analysis,
it says works with all asset classes and that is because
you are just analyzing the historical price data of something,
and everything has some type of historical price data that
can be analyzed. When we go down to what is taken into account
between the two of them, that varies here. With the fundamental
analysis side of things,
we have all kinds of information from financial statements, balance
sheets, press release, estimates, and various other things as well.
When it comes down to technical analysis, it's pretty cut and dry.
We're basically analyzing price and trading volume.
That's about it for technical analysis. The analyze period
that we're taking a look at when we're putting our analysis
in here with fundamental analysis,
like we were discussing being longer-term goals,
we actually are looking for long periods to analyze as well,
generally speaking. Whereas with technical analysis, we're
usually analyzing shorter periods, you know, hours, days, weeks,
these things along those lines. With the history of this,
this is just more of a fun fact, not necessarily something
that we need to cement in our brains, but fundamental analysis
has been around since 1934, like we mentioned with our friend
Mr. Graham. With technical analysis,
it's actually been around a little bit longer naturally,
just by the way that we analyze things based on a historical
pattern, of course, it has existed longer than the ability to analyze reports, right?
Fundamental analysis can be broadly categorized into two main approaches.
The first one is the top down approach. Our friend here,
see his head is down, his top is down. That's why that's funny.
We have the top down approach,
and the idea here is, we focus on the macro factors, the bigger ones.
We see it goes economy, sector, industry, and company, right?
This means we focus on things like the state of the economy,
GDP forecast, unemployment level, interest rates, et cetera. By taking
all these factors into account, the investor tries to make a
forecast about the broader picture. The overall direction
of the economy and the general market trends is the goal that
we're focusing on. Once we have our prediction of the overall
economy in general, the market trends,
this gives us an overall awareness of the sectors and industries
that will be thriving during those types of scenarios.
Once we analyze the economy, once we analyze the particular
sectors that the asset is that we're interested in on, this
is how we get an idea of whether or not we should be interested
in buying, or selling, or doing nothing at all.
The idea is to narrow down the investment horizon by starting
from the global picture up at the top and working our way
to the bottom down, finally making our way to the company
that we're interested in on. When talking about the top-down
approach, we discussed that it means we're using the broader
picture and then working our way smaller.
That means we need to pay attention to those macroeconomic
factors. A good thing for us to focus on would be things
like GDP projections for the U.S., as well as the global market,
the outlook for the interest rates of whatever it is that
we're looking at, or just the currency in general, the bond
price and yields, the inflation levels, the prices for different
commodities that are involved in whatever it is that we're
once again interested in trading on. All of these things are
good examples of places to get started with. If we were to
use interest rates as an indicator, for example, a good sector
to look at would be paying attention to the financial
sector. As a bank's primary income does come from interest
rates, or using those interest rates on loan production,
we can see that there's a correlation between the interest
rate changes, as well as the yields for a 10 year treasury
yield, as far as the graph is going to show. We see that during
the period, where the orange line is representing the interest
rates, as interest rates fall,
we're also seeing the yields fall. As interest rates rise,
we're also seeing the prices rise. During periods where we
rose steeply, the market also rose steeply. During periods where
we fell sharply, the market also fell sharply.
There is a strong correlation here, and this is just to
give us some ideas of other things that we could pay attention to.
When it comes to commodity prices, an easy example is
to look at the price of oil and the companies involved in
the oil production business.
We have a strong positive correlation.
The trend in the oil prices is almost always willing to tell
us about the direction of the share price of oil related
companies. In this example here in this picture on the graph,
we can compare the price of crude oil futures contracts, being
the blue line, to the share price of Exxon Mobil corporation,
which we know is XOM. As the share price rises, what
do we see with the futures contracts?
The futures contracts are also rising and spiking.
There's a very strong correlation here.
They almost mirror each other quite comfortably, all the way
along. When we have a sharp fall,
we have a sharp fall. When we have a sharp rise,
we have a sharp rise. Very, very similar correlation here.
Once again, this is just by paying attention to a commodity,
as well as some of the companies that are related to that
particular commodity. We can translate this example over a
million times into a bunch of other ways, as well when we analyze
a top-down approach.
Then, we have the bottom up approach, which inverts the top down
approach. We actually are going to start on a micro level and work our way up.
Hence the name "bottoms up" in the air there.
As the name suggests, obviously we're starting from the
bottom and we're working our way to the top.
We start on the micro level and work our way to the macro
level. The investors that prefer this methodology believe
that the overall state of the economy may not be indicative
of the performance of a particular stock. Hence, the reason they favorite
in this direction. They think that some of the shares may have a high investment
potential, although being a part of a stagnating sector or
industry, so they prefer to check it out this way. Bottom up
fundamental analysts usually focus on corporate earnings, financial
statements, balance sheets, press releases, letters to investors,
supply and demand estimations, goods and services offered
by the business, as well as other company's specific sources
of information, just to name a few.
Both types of fundamental analysis have their pros and
cons. An example would be with the top down approach, investors
can focus on identifying the well performing sectors and
industries. That way they can narrow down the universe of
potential opportunities and quickly shift between the analysis
of a specific company or another company. Bottom up analysts
on the other hand, get a clearer understanding of a particular
company and its operation. The truth is, no approach is simply
better than the other, it just depends on the situation, as well as
what you prefer. Some of the ways that we can go about
the bottom up approach can be classified as the qualitative
fundamentals. This means, we want to pay attention to things
like the business model and competitive advantages that a
particular company might be offering, as well as pay attention
to the management structure that the company has, maybe
as well as how happy the employees at that company are.
Then, we also have the power of the brand. This is important
to pay attention to as well because this indicates the staying
power that a particular company already has over the market,
such as Coca-Cola, a domineering name.
There are actually equations that we can use when taking
a qualitative approach that will allow us to add a hard number
or value to a company so we can better compare it to other
options out there. If we want to analyze the earnings per
share, otherwise known as the EPS, that is a simple equation
of EPS equals the net income, minus the preferred dividends,
divided by the end of period common shares outstanding. That's
it: Minus up top, divided down below. Then we also have price to
earnings, known as the P/E. Our P/E is going to be our market
value per share, divided by earnings per share.
Nothing too hard there. Then we have our price to book.
Our PB is going to be the market price per share just divided by the
book value per share. Once again, a relatively simple equation.
Keeping it going, if we want to measure the return on equity,
that is going to be equivalent to the net income divided
by the shareholder equity.
Then we have the beta. The beta is going to be the covariance
divided by the variance. Then, we have our projected earnings
growth, known as PEG, which is going to be easily done by price
divided by EPS, divided by the EPS growth. Then finally, we have our dividend
yield, which is going to be equivalent to the annual dividend
divided by the share price.
As you can see, these equations are nothing more than
a simple subtraction and/or division problem.
In conclusion, fundamental analysis is something that you'll
find in many successful traders' arsenals out there.
It's not the same exact thing as technical analysis, but
both of them give a trader a potential edge over the market,
in allowing them to have an expectation of where a particular value might be going.
If you get good enough with it, remember, we always have
the gauntlet mini, which can give you a chance to be a funded
trader, if you are good enough and think you have what it takes to pass the test.
If you're not convinced on fundamental analysis, just take
a look at Warren Buffett's net worth and then get back to
me. Until next time everybody, please make sure you click
the like and subscribe button below, and I will see you in
the next one. Over and out.