One of the key aspects of stock trading is determining the value of a given asset and whether that value will increase or decrease over the length of a position.
The goal of funded traders is to find stocks, assets and positions that will deliver the most value and thus the best returns within acceptable risk tolerances and drawdown limits.
The complexity of determining value is that there are so many ways to determine how valuable a particular asset is, and they often do not agree either with each other, with the book value in the case of a company or with the current market value.
This is important to see if a particular trade will be good value, whether it has strong potential for growth and how long it is expected to see long-term results before it starts to dip. Conversely, it also can be used to see if a stock price has the potential to bounce back.
There are a range of analytical tools and methodologies that can help with this, of which one of the most foundational is fundamental analysis, which attempts to see if a stock is being valued accurately or not.
This form of analysis, which relies heavily on fairly intense research of each asset in question, is typically an indication of the “true” value of a company, forming the bedrock of many trading strategies.
If this is the case, however, why are stocks overvalued or undervalued in the first place? Why is there potential money to be made on trading long positions on undervalued stocks and short positions on stocks driven by factors other than their fundamental financials?
There are a lot of reasons, some of which are simple, predictable and possible to add to trading plans and models to determine the potential for future growth, whilst others are far less predictable, with ramifications outside of the market itself.
To start with, however, it is important to understand what fundamental analysis can explain about an asset’s value, and what it cannot.
What Is Fundamental Analysis?
Fundamental analysis is the most common method used to measure the intrinsic value of an asset, with a process that moves from macroeconomic factors to microeconomic ones.
Typically this starts with the overall economy and its health, before exploring the strength of a given industry before finally evaluating the financial health of the company in question that issues the stock under investigation.
In other words, explorations on which stocks are worth buying and worth exploring ask whether the market as a whole makes it worth buying in, then it looks into a particular industry and its current successes and failures, before finally looking at the qualitative and quantitative data of the particular stock in question.
This analysis, as a whole, should provide a picture of what the company is worth, and by extension what a particular share should be valued at. This is what is often known as a stock’s intrinsic value, or what you should actually be paying for it.
Anything trading below this intrinsic value is undervalued, anything above is overvalued, and in theory, this makes the former worthwhile to buy as the value is set to rise towards this actual worth, whilst the latter should be sold before a potential fall.
This works in stark contrast to technical analysis, which looks less at the intrinsic value of a particular asset and instead explores how an asset’s prices will move based on various indicators and past trends, with an assumption that history tends to repeat itself when it comes to stock movement.
Fundamental analysis works by assuming that the publicly available financial data required from a company issuing a stock will reflect the true value of a company rather than the stock price.
It also assumes that whilst there will be many different estimates of the intrinsic value of a company, the best rule of thumb to use is the average of the different estimates cited. Given that a company needs to be significantly undervalued relative to the average, this is often a good place to start with a strategy.
As well as this, the most central assumption of fundamental analysis is that over a long enough period of time (which will vary between markets, sectors and companies themselves) the price will eventually reflect the fundamental estimates, and buying an undervalued company helps you make significant gains.
There are two main types of fundamental analysis as well, based on whether they rely on quantitative data such as charts and figures, or qualitative data such as a company’s business model, management and business advantages.
This is how fundamental analysis is meant to work, and assuming the modelling and research are correctly undertaken, this is how it will work for many trades in many situations.
People will buy lower than intrinsic value, wait for it to reach that fundamental value or above and then sell, making a profit in the process.
At least, that is how it is supposed to work, and assuming a perfectly rational market this is how it will work.
So why do some stocks end up significantly overperforming or underperforming? There are a lot of potential reasons, some of which are expected and predictable whilst others absolutely are not.
It Has Not Made It Yet
The key issue that some people have with fundamental analysis is that it inherently takes a long-run approach. In other words, a stock will eventually reach this expected price, but the unanswered question is when it will do this.
This is often why technical analysis is used alongside fundamental analysis, in order to evaluate common signals and indicators of market movement, as well as more qualitative analysis about the industry as a whole to determine whether it is a fast-paced growth area.
In these cases, fundamental analysis is used to determine if you should buy a stock before technical analysis is used to evaluate when you should, in the case of long-term stock.
For day traders and short-term positions (if not outright short positions) where time is of the essence, when to trade is far more important than the long-term outcomes of a stock, and during the holding period stock fluctuations endemic to the market are not factored into the fundamental analysis.
A Curveball To Estimates
Fundamental analysis relies on presently known public information in order to derive its estimates, and exactly how much it places weight on developments in a particular market sector can often vary based on the knowledge of the industry an analyst has or how successful said development is.
For example, if a software company’s analysis was based in part on a product that has not currently reached the market, its delay or cancellation would fundamentally change any relevant stock values for the worse.
This is why analysts will typically present a worst-case valuation and an average-case valuation as well as a valuation that assumes an ideal set of scenarios.
Arguably the hardest trades to make are in initial public offerings (IPOs), especially those in new or fast-developing industries.
Very young companies often have little financial data to work on, most of it reflects a company that is spending more than it is earning, and analysis is weighted heavily on the potential for growth and the story it splints about its product or service’s revolutionary potential.
Investing in the relatively novel can have some benefits but the analytical models you need to be successful will be far different from fundamental analysis in the cases of major successes, as the hope is that the hype will eventually translate into tangible, fundamental earnings.
An Assumption Of Rationality
Fundamental analysis as a model is one that relies most on the hypothetical “economic man”, that all traders are ideal decision makers using perfect rationality in their position choices.
This is not always the case of course, as has been seen with asset bubbles where a mix of fear and greed has caused people to buy stock at irrational prices, driving up the stock to levels far beyond what they could possibly be intrinsically worth.
This can happen for a lot of reasons. Sometimes it can be driven by hype, sometimes it can be driven by unsubstantiated speculation, and in other cases, it can happen for seemingly no reason.
In 2021, the video game retail company GameStop, reeling due to previous changes in the market and stay-at-home orders stopping people from shopping at brick-and-mortar stores, suddenly increased in price from under $5 per share to $325 in under a month.
Part of this was based on hopeless optimism, part of it was joke investments in so-called “meme stocks”, and part of it was a short squeeze attempt on a stock with 140 per cent of its float having been shorted.
Whilst it has fallen significantly since then, the company is still trading higher than its 2007 peak despite a fundamental analysis of the industry that makes for somewhat grim reading.
Black Swan Events
Sometimes events cannot be predicted except in hindsight due to their rarity and extreme impact. These are typically known as black swan events and can have major effects on the financial market, which consequently affects the potential for stocks to meet intrinsic valuations.
The Global Financial Crisis of 2008 is a good example of a black swan event that fundamentally shifted the stock market as we know it, with ramifications that are still being felt today.