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Trading Intelligence
How to do Fundamental Analysis?
Fundamental Analysis is a set of methods to estimate the future price of an asset by examining the fundamental data of the asset.
1. What is Fundamental Analysis?
2. What is Fundamental Data?
Political news, corporate news, corporate financials, country financials, corporate statistics, country statistics, news flow and even rumors that affect the prices of the assets are considered as fundamental data. The purpose of the fundamental analysis is to find the true price of the asset by analyzing the positive or negative effects of those fundamental data on the asset.
2.1. News Flow
News from news agencies, news sites, TV and social media are all considered in this class. For example, if we are fundamentally analyze the EURUSD parity, the political news flow in USA and Europe directly affect the value of the parity and we have to analyze all those news too. News in favor of Europe raises the parity. If a company stock is analyzed, news that the company becomes the preferred bidder for a new business has a positive impact on the stock price.
2.2. Financial Statement Data
Financial statements of countries, companies, central banks are considered in this class. If you are doing a fundamental analysis to find the true value of a stock, you need to consider the data like how much the company has sold in the last year, how much credit they have received, how much money they have. These data are available on the periodic financial statements of the company. If a fundamental analysis of a currency is done in the same way, it is necessary to examine the financial statements of the central bank of the country to which the currency belongs.
Microeconomics is the branch of economy that examines the economic behavior of individuals and firms. The tendencies of ordinary citizens to shop, the way corporates do business and manage money goes into the research area of microeconomics. Microeconomic data is the data related with microeconomics such as consumer confidence index, data on company financial statements, purchasing manager index etc.
2.3. Microeconomic Data
2.4. Macroeconomic Data
Macro Economy is the branch of economy that overlooks countries and the world economy. Topics such as monetary policies of central banks, inter-country trade, exchange rate changes are the subjects of macroeconomic research. Amount of reserve assets of central banks, military spending of countries, meeting minutes of central banks are all considered as macroeconomic data.
When fundamental analysis for an asset is done, the real price of the asset is estimated by examining all the fundamental data that can affect the asset price. The data used in the fundamental analysis can be divided into the following groups:
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Macro-Economic News Flow
Let's say, we are trying to find the real price of the stock of a big bank of a country. If the country is in a war, it affects the prices of all the assets in that country and it is expected that this bank has a lower price than other banks in similar countries. News flow related with that war must be examined carefully when calculating the real value of that bank.
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Macro-Economic Financial Statement data
For example, interest rates of a central bank of a country affect the share prices of the banks in that country. In low-interest environments banks can sell more loans and this has a positive effect on the bank's balance sheets. We can expect a bank in a country with low interest rates to have a higher share price than a bank in a country with higher interest rates.
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Micro-Economic News Flow
For example, the fact that a bank merges with another bank is a micro-economic new. Company mergers are expected to have a positive impact on the share prices of merging companies because merging the departments that do the same job reduces company costs and it easier for a larger company to capture market opportunities.
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Microeconomic Financial Statement data
For example, dead loans of a bank affect the share price of that bank. Likewise, the value of a real estate owned by a bank also affects the share price of that bank. The share price of a bank, which has got a valuable real estate, should be higher than one which hasn’t. Such data are found in the financial statements of the banks.
3. How to do fundamental analysis?
3.1. News Flow Analysis
When doing fundamental analysis, news agencies, social media, news published by companies must be followed closely. Immediately after a news story is published, there is a significant change in the price of the assets related with the news story. It takes a while for the news to spread and investors to digest it. Today, it is very easy and fast to reach the news thanks to the developments in technology. Investors who learn before and trade accordingly often win. For example, the Federal Reserve's "dollar is overvalued" statement can cause high volatility in dollar parities within seconds. Tweets of the heads of a country can change the value of the country currency significantly within seconds. Today, there are even algorithms that analyze the tweet streams and make investment decisions.
3.2. Financial Statement Analysis
Analysis of the financial statements includes the examination of the financial statements of the central banks and the companies traded in the stock exchange. If you evaluate a currency of a country, you should examine the financial statements of the central bank of that country. If you evaluate a company, you should examine its financial statements.
The following are the financial statement types listed:
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Balance Sheet
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Income Statement( Profit and loss statement)
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Cash Flow Statement
The items in these statements, what they mean, and calculations on these items require extensive accounting knowledge, so the details of these tables will not be discussed in this article. This article is intended to show the way how to do the fundamental analysis and to teach the most commonly used fundamental data interpretation methods. A good fundamental analyst must understand these statements well and make conclusions from the values of the items.
When analyzing financial statements various ratios are used. These ratios bring the items in the statements together. Ratios are more meaningful numbers to understand how much the market value of the asset is different from its real value and if it is cheap or expensive.
4. Most Commonly Used Financial Statement Ratios
Current Ratio = Current Assets / Current Liabilities
This ratio shows if the assets of the company are sufficient to operate. High values indicate that the company will have little trouble paying debts back.
4.1. Current Ratio
4.2. Net Profit Growth
NPG = ( (NP2 – NP1) / NP1 ) * 100
NPG shows how much the net profit of the company during a certain period of the year has increased or decreased against the same period of the previous year.
High net profit growth is an indication of the increased productivity of the company. Net profit growth should exceed the inflation rate in the same period. NPG below the inflation rate shows profitability of the company decreased in reality.
4.3. Receivables Turnover Ratio (Debtors or Accounts Receivables Ratio)
RTR = Net Credit Sales / Average Accounts Receivable
Net Credit Sales = net credit sold in a period
Average Accounts Receivable = (Accounts Receivable at the beginning of the period + Accounts Receivable at the end of the period) / 2
RTR shows the efficiency of the company in collecting the debts. High RTR means amount of credit sold is high and the amount of debts waiting to be collected is low. Companies desire high RTRs in their business.
4.4. Inventory Turnover Ratio
ITR = amount of goods sold in the period / ( (inventory at the beginning of the period + inventory at the end of the period) / 2 )
ITR shows how fast a company sells its inventories. It is calculated by dividing total amount of inventory sold in a period to the average inventory kept a day during that period. High ITR mean company sells its goods fast and this affects the share price positively.
4.5. Payable Turnover Ratio (Creditors or Accounts Payable Turnover Ratio)
PTR = Net Credit Purchase / Average accounts Payable
Net Credit Purchase = net credit bought in a period
Average accounts Payable = (Accounts Payable at the beginning of the period + Accounts Payable at the end of the period) / 2
PTR shows how quick the company pays its credits back to its creditors. Low PTR shows company doesn’t need to pay its credits back fast, instead it can use this money to produce more. Low PTR affects share price positively.
4.6. Debt / Equity Ratio (a Leverage Ratio)
D/E Ratio = Total Liabilities / Shareholders’ Equity
D/E Ratio shows how much debt needs to be paid in the future from the Shareholders’ Equity. In other words, it shows how much of the company's debt constitutes the assets that can be used for production. It is better for companies that find debt with high interest rates D/E ratio be small. If borrowing is less costly than using the company's own assets, it is better to have a bigger ratio.
4.7. Debt / Assets Ratio (a Leverage Ratio)
D/A Ratio = Total Liabilities / Total Assets
D/A ratio indicates how much of the company's assets are the provision of its debts. A high D/A ratio indicates that the company is more risky. Usually 50% is considered as a reasonable rate.
4.8. Return on Assets
ROA = Net Income / Total Assets
This ratio shows how effectively corporate assets are used. The rate shows how much profit is generated per unit company asset.
4.9. Return on Equity
ROE = Net Income / Shareholders’ Equity
ROE shows how much profits are generated by using the equity for the activities of the company. It is a good indication of how efficiently the company's money is being used. Big numbers affects the share price positively.
4.10. Equity Growth Rate
EGR = Equity of the current period / Equity of the previous period
EGR shows how the richness of the company increased compared to the same period of the previous year. Figures bigger than 1 indicate that the company is enriched, figures smaller than 1 shows company has lost some assets.
4.11. Gross Profit Margin
GP = Gross Profit = Revenue – cost of goods sold
GPM = Gross Profit/ Revenue
The increase in gross profit margins in comparison to the previous financial period means that the firm increases the revenue from sales and reduces the production costs. High gross profit margin has a positive effect on share price.
4.12. Net Profit Margin
NP = Revenue – cost of goods sold - taxes
NPM = Net Profit / Revenue
The increase in net profit margins in comparison to the previous financial period means that the firm increases the revenue from sales after tax deductions and reduces the production costs. High net profit margin has a positive effect on share price.
4.13. Market Value vs Book Value
Market Value = share price * amount of total shares
Book Value = equity
MV/BV = (share price * amount of total shares) / equity
This ratio shows how the market value of the company, which is formed by the investors' perception and psychology, is much or less than the value of the assets that the company owns. Values below 1 indicate that the company shares trade at cheaper prices than the value of assets company actually owns.
4.14. Price - Earnings Ratio - P/E Ratio
P/E = Market Value per Share / Earnings per Share
Earnings per share = net profit / total amount of shares
P/E is the most popular ratio used in fundamental analysis. It shows how much the investors value the unit profit of the company. It is believed that the share prices of companies having low P/E ratios will rise and approach the market average, while those with high P/E ratios will fall.