The Essentials of Fundamental Analysis

Fundamental analysis is a common method for evaluating the true value of a traded financial asset by examining economic and other “hard” data. The main goal is to identify securities that are priced below their fair market value.

---

1. Learn the Basics of Fundamental Analysis

Investment Analysis Framework

Two forces form the overall framework of investment analysis:

(i) Technical Analysis 🔗 The Basics of Technical Analysis

(ii) Fundamental Analysis 🔗 The Basics of Fundamental Analysis

The Goals of Fundamental Analysis

The main goals of fundamental analysis are:

(a) To identify the fair market value of a traded financial security

(b) To identify and assess the risks associated with an investment decision (risk identification is essential for managing your portfolio efficiently)

Fundamental Analysis Framework

A fundamental analysis framework includes all major internal and external factors that can affect the future cash flows of your investment.

(1) Internal fundamental factors

(2) External factors (business, macroeconomic, etc.)

---

2. Investment Risk

There are two main categories and ten specific sources of investment risk. Portfolio risk can negatively affect the future cash flows of an investment and may even result in a total loss of the initial capital.

(I) General Categories of Risk by Their Fundamental Nature

To manage investment risk, we first need to identify its source. Risk can be divided into two main categories: systematic and non-systematic risk. Systematic risk is unpredictable and cannot be controlled. This category mainly includes risks from “black swan” events, such as financial collapses, wars, or the nationalization of local companies by government action.

(II) 10 Categories of Risk

Here are the 10 major categories of investment risk:

1. Business Risk

2. Market Risk

3. Credit Risk or Default Risk

4. Liquidity Risk

5. Interest Rate Risk

6. Financial Risk

7. Inflation Risk

8. Currency or Foreign Exchange Risk

9. Political Risk or Country Risk

10. Systemic Risk

🔗 More: » Investment Risk

---

3. Major Categories of Financial Ratios

Financial ratios are used to evaluate specific companies or industries. They provide a way to compare different companies and industries on aspects such as profitability, debt, book value, and more.

Here are the categories of financial ratios:

1) Balance Sheet Ratios –Measuring Financial Stability

i) Debt-Equity Ratio

ii) Current Ratio

2) Operating Ratios - Measuring Performance

i) Operating Profit Margin

ii) Net Profit Margin

3) Efficiency Ratios – Measuring Efficiency

i) Total asset turnover ratio

ii) Return on Equity

4) Valuation Ratios – Measuring Effectiveness

i) P/E Ratio

ii) P/E/G Ratio

🔗 More: Financial Ratios

---

 

4. Valuing Stocks & Industries

Being able to assess the true value of a company is crucial for making profitable investment decisions. Here are the five most important evaluation methods:

(1) Revenue-Based Valuations

(2) Earnings-Based Valuation

(3) Cash Flow-Based Valuation

(4) Equity-Based Valuation

(5) Empirical Valuation

🔗 More: » More on Investment Valuation Methods

---

5. Commitments of Traders (COT)

The Commitments of Traders (COT) report, issued by the CFTC, shows the total long and short positions in the futures market for all major asset classes, including Forex currency pairs. The COT is an important tool for analyzing market sentiment and predicting future market conditions, especially regarding non-commercial traders’ positions. It is available for all actively traded futures contracts, such as stock indices, interest rates, and currencies.

■ The Commitments of Traders report includes a breakdown of the total futures positions for three different types of market participants:

(1) Non-Commercial traders / large speculators

(2) Commercial Forex traders/hedgers

(3) Small speculators (too small to be reported)

■ COT reports are available for many different asset classes, including::

(a) Stock Futures (equity investors)

(b) Commodity Futures (precious metals, energy, etc)

(c) Currency Futures (including US Dollar against Euro, Japanese Yen, British Pound, Canadian Dollar, Swiss Franc, Australian Dollar, Mexican Peso, Russian Ruble)

🔗 More: » Commitments of Traders Report (CFTC)

---

6. Treasury Bills (T-Bills) and their Correlation with Equity and Forex Markets

All investors should closely watch the bond market. Significant changes in government or corporate bond prices can indicate upcoming economic shifts. In this context, large changes in government bond yields or in the spread between bonds of different maturities may signal what is likely to happen in the real economy, equity markets, and Forex markets. One key factor linking all financial markets is the level of interest rates.

Government Bonds Classification

Government bonds are generally classified by their maturity. There are three main categories:

■ Bills – Mature in less than one year

■ Notes – Mature in 1 to 10 years

■ Bonds – Mature in 10 years or more

Marketable securities are issued as Treasury Bonds. Depending on their maturity, they are called Treasury Bonds, Treasury Notes, or Treasury Bills (T-bills).

🔗 More: » Treasury Bills (T-Bills)

---

7. TIPS: Using Treasury Inflation-Protected Securities to Predict Interest Rates

First issued by the U.S. Treasury in 1997, TIPS are fixed-income securities that pay interest on their face value, like regular bonds. The interest payments are adjusted for the Consumer Price Index (CPI) and include a small additional return.

Key points:

• TIPS are Treasury Bonds designed to protect investors from inflation.

• Deflation can reduce the par value of TIPS, but at maturity, investors never receive less than the original par value.

• TIPS interest rates are lower than those of traditional non-TIPS bonds because they adjust for future inflation.

• In the U.S., TIPS earnings are taxable. If deflation lowers the par value, this reduction can be used to offset other income gains.

• You can buy TIPS directly through a brokerage account or invest in a mutual fund or exchange-traded fund (ETF) that holds TIPS.

🔗 More: » TIPS and How to Use Them for Predicting Interest Rates

 

■ Introduction to the Essentials of Fundamental Analysis

TradingCenter (c)

You are not allowed to publish, reproduce, translate, merge, sell, rent, or distribute any content on this website (TradingCenter). You are also not allowed to create a derivative work or utilize framing techniques to enclose any content on this website (TradingCenter).