Table of contents
Introduction
What is fundamental analysis (FA)?
Comparison of fundamental analysis and technical analysis
Commonly used indicators in fundamental analysis
Earnings per share (EPS)
Price to Earning Ratio (P/E)
Price to Book Ratio (P/B)
Price-to-earnings growth rate (PEG)
Fundamental Analysis and Cryptocurrencies
Network Value to Number of Transactions (NVT) Ratio
active address
Price and mining cost profit and loss ratio
White paper, team and roadmap
Pros and Cons of Fundamental Analysis
Summarize
Introduction
There is no definitive scientific theory behind trading, whether it’s centuries-old stocks or emerging cryptocurrencies. If there is, Wall Street’s top financial figures will definitely keep the formula strictly confidential.
What we have at our disposal are a vast array of tools and methods used by traders and investors. In most cases, these methods can be divided into two categories: fundamental analysis (FA) and technical analysis (TA).
In this article, we’ll dive into the basics of fundamental analysis.
What is Fundamental Analysis (FA)?
Fundamental analysis is a method used by investors and traders to determine the intrinsic value of an asset or business. To accurately assess value, they will delve into internal and external factors to determine whether the underlying asset or business is overvalued or undervalued. The research findings can provide investors and traders with recommendations to help them make decisions that are more likely to yield substantial returns.
For example, if you are interested in a company, you might start by researching things like its earnings, balance sheet, financial statements, and cash flow to learn more about its financial health. Then, branch out and look at the markets or industries in which they operate. Who are the competitors? Who is this company's target audience? Is this company expanding its operations? You can expand the scope even further to take into account many economic factors, such as interest rates and inflation.
This is what is called a "bottom-up" approach: start with a company of interest and work your way up to understanding its position in the macroeconomic environment. Of course, a "top-down" approach can also be used. Look at the big picture first, then zoom out.
The ultimate goal of this type of analysis is to arrive at an expected stock price and compare it with the current price. If the estimated value is higher than the current price, it can be considered undervalued. On the contrary, if it is lower than the market price, it can be assumed that it is currently overvalued. Based on the data obtained from the analysis, an informed decision can be made to buy or sell the stock of a particular company.
Comparison of fundamental analysis and technical analysis
New traders and investors who are new to cryptocurrencies, forex, or the stock market are often confused about which approach to take. Fundamental analysis and technical analysis are in sharp contrast, analyzing different matters in completely different ways. However, both provide transaction-related data. Which method is better?
In fact, it may make more sense to focus on the information provided by each method in combination. Essentially, fundamental analysts believe that the stock price does not necessarily represent the stock's true value and use this as the philosophy behind their investment decisions.
Technical analysts, in contrast, believe that future price movements can be predicted based on historical price action and volume data. They don't care about external factors, but pay more attention to the market's price charts, prices and trends, hoping to determine the ideal points for buying and selling positions.
Supporters of the Efficient Market Hypothesis (EMH) believe that technical analysis (TA) cannot help traders always outperform the market. This theory holds that financial markets already present all known information about assets (so analysts are "rational") and have taken historical data into account. Among EMH supporters, moderates do not deny the role of fundamental analysis, but hardliners believe that even if fundamental analysis is studied rigorously, it is impossible to gain a competitive advantage.
Obviously, there is no objective distinction between these two methods, as both can provide valuable insights into different fields. Some people may be better suited to certain trading styles. In practice, many traders will use the two together to conduct analysis and judgment from a more comprehensive perspective. This is true for short-term trading, and it is also true for long-term investing.
Commonly used indicators in fundamental analysis
When we discuss fundamental analysis, we will not talk about K-line charts, MACD or RSI, but will introduce some specific indicators of fundamental analysis. In this section, we discuss several of the most popular indicators.
Earnings per share (EPS)
Earnings per share is an established measure of a company's profitability, showing how much profit each outstanding share generates. The calculation formula is as follows:
(Net income - preferred stock dividends) / number of sharesSuppose a company pays no dividends and has profits of $1 million. After issuing 200,000 shares, calculated according to this formula, the average earnings per share will be $5. The calculation process is relatively simple, but it can give us an idea of the potential investment. Companies with higher EPS (or consistent growth) are generally more attractive to investors.
Also favored by some is diluted earnings per share, a metric that takes into account factors that could increase the total number of shares outstanding. For example, with stock options, employees can purchase company stock. This typically provides more shares to distribute net income over, so the value of diluted earnings per share is expected to be lower than simple average earnings per share.
Like all metrics, EPS should not be used in isolation when assessing the value of a potential investment. That said, it works better when combined with other analytical tools.
Price to Earning Ratio (P/E)
The price-to-earnings ratio (P/E ratio) compares the stock price to the average earnings per share to assess the value of a business. The calculation formula is as follows:
Stock Price / Average Earnings per ShareAgain, take the same company from above: its average earnings per share is $5. Assuming a trading price of $10 per share, the calculated price-to-earnings ratio is 2. What does this mean? In practice, its significance will depend largely on the results of other studies.
Many people use the profit-to-earnings ratio to determine whether a stock is overvalued (high ratio) or undervalued (low ratio). It is a good idea to compare this number to the P/E ratios of similar businesses. Again, this rule does not apply in all cases and is recommended to be used in conjunction with other quantitative and qualitative analysis methods.
Price to Book Ratio (P/B)
The price-to-book ratio (referred to as the "P/B ratio") can tell us how investors evaluate a company's book value. Book value is the value of a business as defined in financial reports (usually assets minus liabilities). It is calculated as follows:
Price per share / Book value per shareLet’s take the same company example from above again. Assume it has a book value of $500,000. Each share is trading at $10, with a total of 200,000 shares. Book value per share is $500,000 divided by $200,000, which equals $2.50.
Substituting the numbers into the formula, $10 divided by $2.50, yields a price-to-book ratio of 4. On the surface, this doesn't look good. This data shows that the stock is currently trading at four times the company's actual book value. This could indicate that the market may be expecting the company's value to soar, resulting in an overvaluation. If the resulting ratio is less than 1, it means that the company is worth more than the market currently recognizes.
The limitation of the price-to-book ratio is that it is more suitable for evaluating "asset-heavy" companies. After all, this calculation doesn't adequately account for a company with few physical assets.
Price-to-earnings growth rate (PEG)
Price-to-earnings growth (PEG) is an extension of the profit-to-earnings ratio, broadening the scope by taking growth into account. Calculated as follows:
Price to Earning Ratio/Earnings Growth RateEarnings growth rate is an estimate of how much a company's earnings are expected to grow over a specific time frame. This metric is usually expressed as a percentage. Let's say we estimate the company in the example above to grow an average of 10% over the next five years. We divide the P/E ratio of 2 by 10, which gives us a ratio of 0.2.
The value indicates that this company is worth investing in because it is significantly undervalued when future growth is taken into account. Generally speaking, any company with a ratio less than 1 is undervalued. Conversely, companies with a ratio greater than 1 are overvalued.
The PEG ratio is preferred over the P/E ratio because the former takes into account an important variable that the P/E ratio ignores.
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Fundamental Analysis and Cryptocurrencies
The above indicators don't really apply to cryptocurrencies. Instead, you may need to rely on other considerations when evaluating a project's feasibility. The next section will look at some of the indicators used by cryptocurrency traders.
Network Value to Number of Transactions (NVT) Ratio
The NVT ratio is often considered the price-to-earnings ratio of the cryptocurrency market and is quickly becoming an important indicator for cryptocurrency fundamental analysis (FA). The calculation is as follows:
Network value / daily transaction volumeNVT attempts to explain the value of a specific network based on the value of the transactions processed. Suppose there are two projects: currency A and currency B. Both have a market capitalization of $1 million. Coin A has a daily trading volume worth $50,000, while Coin B has a value of $10,000.
Coin A has an NVT ratio of 20, and Coin B has an NVT ratio of 100. We generally identify assets with lower NVT ratios as undervalued, and assets with higher NVT ratios as overvalued. This data shows that Coin A is undervalued compared to Coin B.
active address
Some measure usage by the number of active addresses on the network. While unreliable as a single metric (and can be manipulated), it can still reveal information about network activity. You can take this metric into consideration when truly evaluating a digital asset.
Price to Mining Cost Breakeven Ratio
The price-to-mining-cost breakeven ratio is a measure of the value of proof-of-work tokens, which are mined by network participants. This metric takes into account mining costs, namely electricity and hardware consumption.
Token market price/mining cost of one tokenThe price to mining cost breakeven ratio can indicate the current state of a blockchain network. The break-even point refers to the cost of mining a unit of tokens. For example, if the equilibrium point is $10,000, a miner will typically spend $10,000 to mine a new unit.
Assume that the trading price of currency A is US$5,000 and the trading price of currency B is US$20,000. The break-even point of both is US$10,000. Coin A has a break-even ratio of 0.5, while Coin B has a break-even ratio of 2. A ratio of Coin A is less than 1, indicating that miners are mining the coin at a loss. Participating in the mining of currency B is obviously profitable. For every US$10,000 in mining costs, you can expect to earn US$20,000.
With incentives, this ratio is expected to move toward 1 over time. For Coin A, unless the price rises, miners who mine at a loss may leave the network. Coin B can bring huge profits, so more miners are expected to join it until it is no longer profitable.
The validity of this indicator is controversial. Even so, it still gives you an idea of the economics of mining. You can incorporate this into your overall assessment of digital assets.
White paper, team and roadmap
Some traditional project research methods are also popular methods for determining the value of cryptocurrencies and tokens. Read the white paper to understand the project's goals, use cases, and technology. Team members’ track records show their ability to build and scale products. Finally, the roadmap can be used to determine whether the project is progressing as planned. It can supplement other studies to determine the likelihood that a project will achieve its milestone goals.
Pros and Cons of Fundamental Analysis
Advantages of fundamental analysis
Fundamental analysis is a very reliable way to evaluate a business in a way that beats technical analysis. For global investors, examining a range of qualitative and quantitative factors is an important starting point for trading.
Fundamental analysis can be performed by anyone and relies on proven techniques and readily available enterprise data. At least that's the case in traditional markets. In fact, if we focus on cryptocurrencies (still a niche field), we will find that sometimes no data is available, and the effectiveness of fundamental analysis can be greatly reduced due to the strong correlation between different assets. .
When used correctly, it can provide the basis for identifying stocks that are currently undervalued, but will appreciate in value over time. Top investors like Warren Buffett and Benjamin Graham have demonstrated that rigorous study of businesses in this manner can yield tremendous results.
Disadvantages of fundamental analysis
Fundamental analysis is easy to do, but it is not easy to do it well. Determining a stock's "intrinsic value" is time-consuming and involves much more than plugging numbers into a formula. Many factors need to be assessed, and the learning curve for acquiring effective assessment skills is quite steep. What's more, it's more suitable for long-term trading than short-term trading.
This type of analysis also ignores some powerful market forces and trends that technical analysis can identify. As economist John Maynard Keynes said:
"The market can remain irrational longer than you can remain solvent."
Stocks that appear to be undervalued (by all metrics) may not necessarily increase in value in the future.
Summarize
Fundamental analysis is a proven practice that some highly successful traders rely on. By refining their strategies, investors can not only learn to better estimate the true value of stocks, cryptocurrencies, and other assets, but also gain insights into entire businesses and industries.
Fundamental analysis combined with technical analysis can give traders and investors a comprehensive understanding of which assets and businesses can profit from them. Whether it is the traditional market or the cryptocurrency market, the combination of fundamental analysis and technical analysis is favored by many people.
However, the cryptocurrency market is still a nascent field, and we must realize that fundamental analysis may not always achieve the desired results. Be sure to do your own research to ensure you implement a solid risk management strategy.
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