Fundamental analysis is a method of evaluating the intrinsic value of an asset by analyzing its underlying fundamentals. In other words, fundamental analysis involves looking at the underlying factors that affect the performance and value of a cryptocurrency, such as financial statements, market trends, and macroeconomic conditions.
Despite its potential to provide valuable insights into decision-making, fundamental analysis has several pitfalls when applied to cryptocurrency investing. Therefore, before diving into associated risks, it is essential first to understand how fundamental analysis works.
How fundamental analysis works
Fundamental analysis facilitates an in-depth security evaluation to determine its fair market value. Analysts establish the fair value from a macro-to-micro perspective; analysts begin by examining the macro or overall state of the economy and crypto industry, followed by analyzing the financial performance of the company issuing the cryptocurrency. By engaging in this comprehensive approach, analysts can ascertain if a particular cryptocurrency value is in line with its intrinsic value.
Sources of fundamental analysis include:
1. Intrinsic value – Financial analysis holds that a crypto’s true worth is best reflected not in its current market price but in the data related to its fundamentals. Thus, carefully scrutinizing a firm’s performance and prospects allows an investor to pinpoint its intrinsic value and thus discern whether it is trading at a discount or premium. Armed with such insight, one can speculate confidently that the markets will eventually adjust their perspective and reward those who have identified mispricings accordingly.
2. Business model – Examining a company’s business model is paramount for understanding its long-term sustainability and potential. Assessing the success of its products, the strength of its management team, and other factors allow investors to gain insight into whether or not the investment in question will likely generate returns over time.
3. Competitive advantage – A vital component of any business model is its ability to maintain a competitive advantage in its industry. Competitive advantage can take many forms, such as a low-cost production structure, technological superiority, or strong brand equity. Understanding a company’s competitive advantages is essential for its long-term profitability potential.
4. Balance sheet – Assessing the status of a company’s balance sheet is essential for evaluating its ability to finance operations and growth. Analyzing cash flow statements, income statements, and other documents allow investors to gain insight into whether or not a given crypto is undervalued or overvalued based on its true potential.
5. Cash flow – A statement of cash flows outlines the cash inflows and outflows that occurred within an entity over a given period. It is a valuable tool for determining cash movement within an organization, particularly regarding CFI, CFF, and OCF activities. CFI refers to cash used for purchases or sales of long-term investments or assets, while CFF involves transactions related to debt increases or decreases. OCF covers all other business-related expenses and income associated with daily operations. Together, these items provide an overall picture of how the entity is doing financially.
Quantitative vs. qualitative fundamental analysis
Fundamental analysis falls into two categories: quantitative and qualitative. Quantitative analysis uses numerical data (such as stock prices, income statements, etc.) to measure the value of a cryptocurrency. In contrast, the qualitative analysis focuses on non-numerical factors such as company management quality and competitive position in the market.
Fundamental vs. technical analysis
In contrast to fundamental analysis, technical analysis is a method of evaluating the price momentum of an asset by studying its chart patterns. Technical traders attempt to predict future prices based on past performance rather than assessing intrinsic value.
15 Pitfalls associated with fundamental analysis
Though fundamental analysis can offer investors valuable insight into the value of a cryptocurrency, there are several pitfalls associated with it. These include:
1. Over-reliance on qualitative factors – Fundamental analysis considers quantitative and qualitative factors when assessing a security’s fair market value. However, overemphasizing the latter can lead to an inaccurate assessment because management teams can efficiently manipulate such data for their benefit.
2. Lack of historical information – When analyzing any security, analysts need access to reliable historical data to assess its current and future performance prospects accurately. Unfortunately, due to the nascent state of the crypto industry, many companies still need publicly available records from which analysts can draw.
3. Over-simplification – Due to the complex nature of cryptocurrencies, fundamental analysts must conduct a comprehensive examination to assess their value accurately. Failure to consider all relevant factors can lead to an over-simplified and inaccurate assessment of the security’s intrinsic value.
4. Ignoring macro environment – Analysts often overlook the larger economic, political, and social forces that can significantly impact a cryptocurrency’s valuation. It usually applies to emerging markets with less mature industry regulations, such as those in the crypto market.
5. Taking too long a time horizon – Fundamental analysis can sometimes take time due to its need for detailed analysis across various variables. The initial assumptions and forecasts need to be updated when they take too long.
6. Focusing on one variable only – Fundamental analysts must understand that all variables are interrelated, and failure to take into account multiple factors can lead to an inaccurate assessment of risks and rewards associated with a security.
7. Unfamiliarity with data sources – Analysts need access to reliable data sources such as financial statements or industry reports to assess a cryptocurrency’s value accurately. If these sources are unfamiliar, it can lead to unreliable data in their calculations and, thus, an inaccurate assessment of the security’s intrinsic value.
8. Overconfidence – Analysts who are overly confident in their analysis can fail to account for unexpected developments that may impact the security’s future performance. Overconfidence can cause investors to overestimate their returns and underestimate the risks associated with a security.
9. Lack of objectivity – Fundamental analysis relies on subjective judgment to determine what factors are essential when assessing the value of a security. Analysts must remain impartial to accurately decide on all relevant information and make sound investment decisions.
10. Ignoring market sentiment – Market sentiment can have an enormous impact on the price action of any asset, including cryptocurrencies. As such, fundamental analysts must be sure to factor it into their analyses to formulate accurate predictions about future prices and identify entry/exit points for trades.
11. Lack of regulatory clarity – Cryptocurrencies still need to be more regulated, which means that the rules governing their sale and use can change frequently. Lack of regulation increases the risk of investing in these assets as it can be difficult to accurately assess their actual value due to the lack of regulatory oversight.
12. High levels of volatility – Cryptocurrencies are known for their high levels of price volatility, making it difficult to gauge their actual value accurately. As such, fundamental analysts must be sure to factor in the potential for sudden and dramatic price swings when making investment decisions.
13. Difficulty in valuing – Due to their complex nature, cryptocurrencies can be difficult to value accurately. As a result, fundamental analysts must consider a range of variables to assess their current and future value accurately.
14. Misunderstanding of technology – Fundamental analysts must understand the technology behind the cryptocurrency they are analyzing to assess its potential risks and rewards effectively. Failure to do so can lead to erroneous predictions about its future performance.
15. Difficulty in predicting technological changes – The technology behind cryptocurrencies is constantly evolving, so analysts must be able to accurately predict how changes in the technology will impact their future performance. Advancements can be challenging due to the highly speculative nature of the blockchain industry.
Fundamental analysis is a powerful tool for investors looking to capitalize on the potential of cryptocurrencies. However, analysts must understand and consider the many challenges associated with valuing these assets to assess their actual value and make sound investment decisions accurately. By being aware of the pitfalls and remaining diligent in their research, fundamental analysts can significantly increase their chances of success when trading cryptocurrencies.