The choice of which approach to use in determining market direction has been a long standing argument between advocates of fundamental analysis and those who mercilessly deride its usefulness. The point of this article is not to take sides but to try and point out how the average trader can use fundamental analysis as a tool, and benefit from it.
How it works
Fundamental analysis is based on the study of the forces that control the economy, carried out in such a way as to provide information that can be used to predict market developments. Fundamental analysis involves the study of the economy, the study of an industry and the study of a company or companies in that industry. The results of these studies put together can help a trader establish the true value of the company’s stocks and forecast the direction the value of the stocks will take in the future. Fundamental analysis tries to determine the value (intrinsic value) of a company’s stock by analyzing financial data about the company and the environment where they operate. This analysis assumes that over time, a company’s stock price will reflect its intrinsic value
Uses of Fundamental Analysis in Trading
The effectiveness of fundamental analysis in trading depends on a number of factors. One of these is the quantitative measure. Quantitative measures are factors that can be measured or expressed in numerical terms; such as the company’s revenue, earnings, assets and liabilities. The result of this measurement is then compared against that of other companies in the industry, the overall industry and previous results from the target company.
Another factor to consider is the qualitative factor. This relates to the nature of the company and looks at information such as: its competitive advantage, management experience and performance, its business model and brand loyalty. These factors are necessary in accessing the viability and future performance of the company.
Quantitative analysis and qualitative analysis are mutually complementing and beneficial to the investor. One cannot be used outside the other as they both seek to capture separate data that only when used together can help an investor determine a company’s market direction.
Tools for fundamental Analysis
There are some tools that are important for carrying out fundamental analysis. These tools help the investor focus on earnings, growth and value in the industry.
Earnings per Share, Price to Earnings Ratio, Projected Earnings Growth, Price to Book, Dividend Payout Ratio, and Return on Equity.
In the short term, a stock price might have good fundamentals but still be moving in the wrong direction. This can be as a result of several factors such as News release and market changes. Fundamental analysis is usually used by long term investors, but combining it with technical analysis will provide a better insight into the viability of a particular stock.