- 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 company is 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 operations
- 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
