- Fundamental Analysis
- Micro Analysis
- How to Use it
What is Fundamental Analysis
- Fundamental analysis is the cornerstone of investing
- It is the study of all the relevant factors that affect an economy, market or asset class in order to find its intrinsic (fair) value
- Analysis of factors affecting the economy as a whole is known as macroeconomic analysis
- Analysis of the factors affecting a specific companyis known as microeconomic analysis
What is the Intrinsic Value
- Fundamental analysis assumes that the price on the stock market does not fully reflect a stock’s “real” value
- This “real” value is known as the stock intrinsic value
- The second assumption of fundamental analysis is that in the long run, the stock price will reflect the fundamentals
- If this intrinsic value is above the current market price, then the asset is underpriced and should be bought
- If the intrinsic value is below the current market price, then the asset is overpriced and should be sold
Macroeconomic Analysis
- Macroeconomic analysis is used in the evaluation of currencies, bonds, commodities, and stock indices
- At the macro level, analysis examines factors that affect the economy in its entirety
- Interest rates, inflation, rate of growth, employment, politics, and national sentiment
- This analysis will tell us if the economy is expanding or contracting or if its booming or in a slump
Economic and Business Cycle
- From boom going into recession the economic growth will slow and we will witness a decrease in investments and production
- From recession to slump inflation will drop and unemployment will rapidly increase
- From slump to recovery interest rates will decrease and housing activity and spending will increase
- From recovery to boom we have growth, spending will increase, inflation will rise, and employment will reach its full capacity
- Where we are in the cycle decides on which asset class we should invest in. e.g. in recession stocks go down and bonds up
Microeconomic Analysis
- Microeconomic analysis is used in the evaluation of individual stocks or corporate bonds
- The term refers to the analysis of the economic well-being of a financial entity as opposed to only its price movements
- Traders analyze the financial statements of a company in order to decide if its stock is a good investment
- Is the company’s revenue growing? Is it making profits? Can it repay its debts? What is the fair value of its stock?
- In the long run, a stock’s price is driven by a company’s ability to grow sales and earnings but also the economic conditions
- Micro Economics
- Company Financials
- Financial Statements
- Financial Ratios
Financial Statements – The Balance Sheet
- Traders analyze the financial statements of a company in order to decide if its stock is a good investment
- The balance sheet, income statement, and cash flow statements reveal the financial makeup of the company
- The balance sheet compares the company’s assets to its liabilities and owner’s equity
- The balance sheet explains to us how the company raises money in order to acquire its assets
Financial Statements – Income and Cash Flow
- The income or profit and loss statement reveals how the company earns money
- The cash flow statement shows how the company uses its cash to operate and how much of this cash is borrowed
- In the profit and loss statement, expenses are deducted from the revenues to show the firm’s net profits (earnings)
- The higher the company’s net profits, the bigger the returns for the owners, paid as shareholders dividend
- The higher the profitability and hence the dividends of a company, the more attractive it is
Financial Ratios – Valuation
- Out of several investment valuation ratios, the most commonly used is the P/E ratio
- Since price alone doesn’t show the value, this ratio compares the price of the share to the amount of earnings it generates
- It provides investors with a quick idea of how much they are paying for each $1 of earnings
- Investors compare the Price Earnings ratio of one company to its competition – the best shares are those with the LOWEST PE
Financial Ratios – Dividend Yield
- When a company earns profits, it can reinvest the profits into the business, called retained earnings
- The part of the profits that is not retained, is distributed as a payment to shareholders, called dividend
Dividend yield measures in how many years, you will get your initial investment back
Investors compare the dividend yield ratio of one company to its competition – the best shares are those with the HIGHEST DY
Financial Ratios – Liquidity
- Liquidity ratios look into the ability of a company to pay its debts and still fund its ongoing operationsv
- Current Ratio = Current Assets / Current Liabilities
- The Current Ratio reveals whether a company has enough cash to pay off its short-term liabilities
- A low liquidity ratio means the company does not have a lot of available cash which could hinder its operations
- Investors compare the current ratio of one company to its competition – the best shares are those with the HIGHEST ratio
Financial Ratios – Return
- Return on Assets (ROA) shows how the company is employing its assets to make profits – the higher the return the better
- Return on Equity (ROE) measures how much the shareholders earned for their investment – the higher the ratio the better
- Investors compare these ratios of one company to its competition – the best shares are those with the HIGHEST ratio
Financial Ratios – Debt
- The Debt Ratio compares a company’s debt to its assets in order to know about the level of leverage – the lower the better
- Debt-Equity Ratio measures how much creditors have committed to the company versus its shareholders – low percentage means low leverage
- Investors compare these ratios of one company to its competition – the best shares are those with the LOWEST ratios
Microeconomic Analysis
- Among the dozens of financial ratios available, we’ve only covered few
- These covered will give you a fair idea about the share you want to invest in
- It is essential to research more about microeconomic analysis and use it for future better educated trading decisions
