Contents
Introduction
What is fundamental analysis (FA)?
Fundamental analysis (FA) or technical analysis (TA).
Popular Indicators for Fundamental Analysis
Earnings per share (EPS)
Price/earnings ratio (PER)
Price/Book Value Ratio (Price-to-book – PBR)
Price/earnings ratio (price-earnings to growth – PEG)
Fundamental analysis and cryptocurrencies
Value per network transaction (NVT) ratio
Active addresses
Mining price/cost ratio
White paper, team and roadmap
Advantages and Disadvantages of Fundamental Analysis
To conclude
Introduction
In trading, whether you're managing century-old stocks or fledgling cryptocurrencies, no exact science exists. Or, if it exists, Wall Street's biggest wigs make sure the formula remains a well-kept secret.
What we have instead is a wide range of tools and methodologies employed by traders and investors. Essentially, you can classify these techniques into two categories: fundamental analysis (FA) and technical analysis (TA).
In this article, we will cover the basics of fundamental analysis.
What is fundamental analysis (FA)?
Fundamental analysis is a method used by investors and traders to attempt to establish the intrinsic value of assets or companies. To accurately value them, they will rigorously study internal and external factors to determine whether the asset or business in question is overvalued or undervalued. Their findings can then help better define a strategy that will be more likely to produce good returns.
For example, if you're interested in a company, you might first study things like the company's earnings, balance sheets, financial statements, and cash flow to get an idea of its financial health. You can then step back from the organization to examine the market or industry in which it operates. Who are the competitors? Who is the company targeting? Is it expanding its reach? You can step back even further to consider macroeconomic considerations like interest rates and inflation, to name just a few factors.
The above is what's called a bottom-up approach: you start with a company you're interested in and work your way up to understand its place in the broader economy. But you can also take a top-down approach, in which you narrow down your choices by looking at the big picture first.
The end goal of this type of analysis is to define an expected stock price and compare it to the current price. If the figure is higher than the current price, you can conclude that the company is undervalued. If it is below the market price, we can conclude that it is currently overvalued. Armed with the data from your analysis, you can make an informed decision whether to buy or sell the stock of that particular company.
Fundamental analysis (FA) or technical analysis (TA).
Traders and investors new to the cryptocurrency, forex, or stock markets are often unsure of which approach to take. Fundamental analysis and technical analysis are in close contrast and rely on significantly different methodologies to analyze different things. And yet both provide relevant data for trading. So which one is better?
In fact, it may be wiser to ask what each allows. In essence, fundamental analysts believe that a stock's price is not necessarily indicative of its true value. An ideology that underpins their investment decisions.
Conversely, technical analysts believe that future price movements can be predicted to some extent from past price action and volume data. They are not concerned with the study of external factors, but prefer to focus on price charts, patterns and trends of the markets. They aim to identify ideal points for entering and exiting positions.
Proponents of the Efficient Markets Hypothesis (EMH) believe that it is impossible to consistently outperform the market through technical analysis (TA). The theory suggests that financial markets represent all known information about assets (that they are “rational”) and that they take historical data into account. “Less radical” versions of EMH do not discredit fundamental analysis, but “radical” forms argue that it is impossible, even with rigorous research, to achieve competitive advantage.
Of course, there is no objectively best strategy, as both can present valuable insights in different areas. Some lend themselves better to certain trading styles, and in practice many traders use a combination of the two to look at the bigger picture. This is true for both short-term trading and long-term investing.
Popular Indicators for Fundamental Analysis
We do not look at candlesticks, MACD, or RSI for fundamental analysis information. Instead, we use a handful of AF-specific indicators. In this section we will talk about the most popular ones.
Earnings per share (EPS)
Earnings per share is an established measure of a company's profitability, telling us how much profit it makes for each share outstanding. It is calculated using the following formula:
(net income - preferential dividends) / number of sharesSuppose a company pays no dividends and its profit is $1 million. With 200,000 shares issued, the formula gives us an EPS of $5. The calculation is not particularly complex, but it can give us insight into potential investments. Companies with higher (or growing) EPS are generally more attractive to investors.
Diluted earnings per share are favored by some because it also takes into account factors that could increase the total number of shares. In the case of stock options, for example, employees have the opportunity to purchase shares of the company. As this generally results in a higher number of shares to divide net income, we expect to see a lower value for diluted EPS compared to simple EPS.
As with all metrics, earnings per share should not be the only metric used to value a potential investment. That said, it's a really handy tool when combined with others.
Price/earnings ratio (PER)
The price-to-earnings ratio (or PER) evaluates a company by comparing the share price to its earnings per share. It is calculated using the following formula:
share price / earnings per shareWe'll reuse the company from the previous example, which had an EPS of $5. Let's say the stock is trading at $10, which would give us a P/E of 2. What does this mean? Well, that largely depends on what the rest of our research shows.
Many use P/E to determine whether a stock is overvalued (if the ratio is higher) or undervalued (if the ratio is lower). It is good to take this figure into account when comparing it to the PER of similar companies. Again, this rule does not always hold true, and so it is best used in conjunction with other quantitative and qualitative analysis techniques.
Price/Book Value Ratio (Price-to-book – PBR)
The price-to-book ratio (also known as the price-to-equity ratio or P/B ratio) can tell us about how investors value the company relative to its book value. Book value is the value of a company as defined in its financial reports (generally, assets minus liabilities). The calculation is as follows:
price per share / book value per shareLet's go back to our previous company. We'll assume it now has a book value of $500,000. The stock is trading at $10, and there are 200,000 of them. So the book value per share is $500,000 divided by 200,000, which gives us $2.5.
If we substitute its values into the formula, $10 divided by $2.5 gives us a price-to-book ratio of 4. At first glance, this doesn't seem positive. This tells us that the shares are currently trading at a price four times higher than the company's actual value on paper. This could suggest that the market is overvaluing the company, perhaps expecting huge growth. If we had a ratio below 1, it would indicate that the company is more valuable than the market currently recognizes.
One of the limitations of the price-to-book ratio is that it is better suited to the valuation of “asset-heavy” companies. In fact, companies with few physical assets are not well represented.
Price/earnings ratio (price-earnings to growth – PEG)
The price-earnings-to-growth (PEG) ratio is an extension of the price-earnings ratio, broadening its scope to account for growth rates. He uses the following formula:
price earnings/earnings growth rate ratioThe earnings growth rate is an estimate of the expected earnings growth for the company within a defined time frame. We express it as a percentage. Let's say we estimated an average growth of 10% over the next five years for the previous company. We take the price-to-earnings ratio (2) and divide it by 10 to arrive at a ratio of 0.2.
This ratio would suggest that the company is a good investment, as it is significantly undervalued when we take future growth into account. Any company whose ratio is less than 1 is considered undervalued. Anything above 1 could be overvalued.
The PEG ratio is preferred to the PER by many, because it takes into account a fairly important variable that the PER omits.
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Fundamental analysis and cryptocurrencies
The aforementioned parameters are not really applicable to cryptocurrencies. Instead, you can look to other factors to assess the viability of a project. The following section presents a handful of indicators used by cryptocurrency traders.
Value per network transaction (NVT) ratio
Often considered the equivalent of the cryptocurrency markets' PER, the NVT ratio has quickly become an essential element of cryptocurrency AF. It can be calculated as follows:
network value / daily transaction volumeNVT attempts to interpret the value of a given network based on the value of the transactions it processes. Suppose you have two projects: currency A and currency B. Both have a capitalization of $1,000,000. However, currency A has a daily trading volume of $50,000, while that of currency B is $10,000.
The NVT ratio for currency A is 20, and the NVT for currency B is 100. In general, assets with a low NVT ratio are considered undervalued, while those with a high ratio may be considered overvalued. This suggests that currency A is undervalued relative to currency B.
Active addresses
Some look at the number of active addresses on a network to gauge the quantity of addresses in use. Although it is not a stand-alone indicator (the measurement can be manipulated), it can still reveal information about network activity. You can factor this into your true valuation of a given digital asset.
Mining price/cost ratio
The mining price/cost ratio is a metric for evaluating proof-of-work coins, which are mined by network participants. It takes into account the costs associated with this process: electricity and material expenses.
Market price of a currency / cost of mining a currencyThe price/cost ratio of mining can tell a lot about the current state of a blockchain network. Mining price-to-cost ratio breakeven refers to the cost of mining a unit of value. For example, if it is $10,000, then miners typically spend $10,000 to generate a new unit.
Let's assume that currency A is trading at $5,000 and currency B is trading at $20,000, and both have a mining cost of $10,000. The ratio of currency A will be 0.5, while that of currency B will be 2. Since the ratio of currency A is less than 1, this tells us that miners are operating at a loss to mine this currency. Mining currency B is profitable because, for every $10,000 spent on mining it, you can expect to earn $20,000.
Due to incentives, one would expect the ratio to tend toward 1 over time. For currency A, those mining at a loss will likely leave the network unless the price increases. Currency B offers an attractive reward, so you would expect more miners to join its network and profit from it until it is no longer profitable.
The effectiveness of this indicator is contested. It does, however, give you an idea of the economics of mining, which you can factor into your overall valuation of a digital asset.
White paper, team and roadmap
The most common method for establishing the value of cryptocurrencies and tokens involves good old-fashioned research into the project. Reading a white paper helps you understand a project's goals, use cases, and technology. The team members' backgrounds give you an idea of their ability to build and scale the product. Finally, a roadmap tells you if the project is on track. It can be supplemented with additional research to determine the likelihood that the project will achieve its objectives.
Advantages and Disadvantages of Fundamental Analysis
Benefits of Fundamental Analysis
Fundamental analysis is a robust methodology for evaluating companies in a way that technical analysis simply cannot compete with. For investors around the world, studying a range of qualitative and quantitative factors is a crucial starting point for any trade.
Anyone can perform fundamental analysis because it relies on proven techniques and readily available financial data. Or at least that’s the case in traditional markets. Indeed, if we look at cryptocurrencies (still a small sector), data is not always available, and high correlation between assets means that AF might not be as effective.
Done well, it allows you to identify stocks that are currently undervalued and likely to appreciate over time. Leading investors, such as Warren Buffett and Benjamin Graham, have consistently demonstrated that rigorous business research can yield great results.
Disadvantages of Fundamental Analysis
It is easy to perform fundamental analysis, but it is more difficult to perform good fundamental analysis. Determining the “intrinsic value” of a stock is a time-consuming process that requires much more work than simply substituting numbers into a formula. Many factors need to be evaluated, and the learning curve to do so effectively can be steep. Additionally, AF is more suitable for long-term trading than short-term trading.
This type of analysis also overlooks powerful market forces and trends that technical analysis can identify. As economist John Maynard Keynes said:
The market can stay wrong longer than you can maintain your creditworthiness
There is no guarantee that stocks that appear undervalued (based on indicators) will appreciate in the future.
To conclude
Fundamental analysis is an established practice that some of the most successful traders swear by. By refining a strategy, investors can not only learn to better estimate the true value of stocks, cryptocurrencies, and other assets, but also better understand companies and industries as a whole.
Combined with technical analysis, fundamental analysis can give traders and investors an in-depth understanding of which assets and companies they could profit from. The combination of AF and AT is favored by many within the traditional and crypto markets.
Given the newness of the cryptocurrency markets, however, you should understand that AF may not be as effective. Always do your own research and make sure you have a solid risk management strategy in place.
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