Lets start by looking at fundamental analysis:
When issuing buy, sell, or hold, recommendations, an analyst is most likely to have undertaken a large amount of detailed research. Companies that are being analysed will be compared to others that trade within the same business sector, and also against the economic outlook. Up-to-date data will be used, and this information will be manipulated to produce comparable theoretical valuations, from which an investment recommendation can then be made.
When analysing publicly traded companies, investors who adhere to fundamental analysis as their valuation method will look to buy the shares of relatively undervalued stocks. To achieve this comparison, standardized formulas and ratios are used, which allows companies to be measured against each other almost at a glance.
Fundamental analysis requires the examination of the financial elements of a trading company such as sales, profit, cash flow and balance sheet. These numbers can be crunched to produce theoretical valuations of companies at any given time.
Profit margins, return on equity and return on investment ratios, as well as the estimated future earnings and revenue of a company can be used to measure results and prospects against others. Of course, fundamental analysts will also take into consideration the wider economy, changes in laws and regulations, and also the political climate when making final recommendations. Geographic considerations – trade between different regions, for example – will also be considered.
The approach taken by fundamentalists will usually either be top down, where emphasis is placed upon the economy, then the business sector, and finally individual companies, or bottom up, where the emphasis is reversed. A top down approach will place greater regard on business sector and the economic cycle, whereas the bottom up approach regards the fortunes of the company most highly.
Fundamental investors tend to have a longer term outlook when making investment decisions. They understand that the market moves daily, but believe that these daily fluctuations are no more than ‘noise’ which should be largely ignored: in other words, the belief is that it is sentiment that drives the market from day to day, but changing company fundamentals that present value opportunities. Just because the market has taken a dive because of, say, war in the Middle East, doesn’t mean to say that the prospects for ‘ABC’ have worsened, even though the share price has fallen along with the rest of the market.
Mutual funds will use fundamental analysis as a basis for investment decisions, and there are several high profile investors that do likewise. Perhaps the best known of these is the so called Oracle of Omaha, Warren Buffet. His Berkshire Hathaway funds actively look for companies they consider to be relatively undervalued, perhaps because of short term results or negative market sentiment, and then buy sometimes large stakes in them. Buffet believes in the long term trend of economic growth, and that downturns are part of the normal business cycle and present opportunities to buy, rather than sell. One of his stated investment edicts is ‘buy and never sell’.
Typical fundamental analysis ratios include:
Earnings Per Share (EPS)
This is the net earnings made by the company divided by the number of shares. This ratio allows the earnings of companies to be easily and cleanly compared to each other. The higher this number, the more profit per dollar investor capital is being made.
Price to Earnings Ratio (P/E)
This is simply the current share price divided by the annual earnings per share. This will give a number that represents how many years of earnings at current levels will be required to recoup the value of one share. Easily calculated and understood, it is one of the most common ratios used to compare relative valuations of stocks against each other and the broader market.
The dividend yield is another easy to calculate ratio, and is expressed as a percentage. It is the amount of annual dividend expressed as a percentage of the share price (dividend/ share price x 100). This makes it easy for income investors to compare stocks against each other, and also to other income yielding investments such as bank accounts and bonds.
Projected Earnings Growth (PEG)
Many fundamental analysis ratios are historic. The PEG is a forward looking ratio, because it is based on anticipated earnings growth. It is calculated by dividing the P/E by the projected rate of growth in earnings.
For example, a stock with a P/E of 15 and a projected rate of earnings growth of 10% would have a PEG of 1.5 (15/10). This number can then be used to compare against other similar stocks to examine relative forward valuations.
And Now Onto Technical Analysis
Though it may seem crazy, technical analysts have little to no regard for the value of a company. They use historic price data to observe stock price movement patterns and predict the direction of that price in the future. Like fundamental analysts, they, too, use common formulas and ratios to do this, though where a fundamentalist would number crunch share price and earnings to come to a price to earnings ratio that can be compared against other companies, technical analysts would, say, use stock price and rate of change to measure volatility. Other technical analysis measurements of future price movement would include relative strength index, moving averages, and regressions.
Technical analysts use historic price and volume data to then apply their analytical methodology and predict future stock price direction. As discussed above, stock prices change on a daily, even second-by-second basis. For this reason technical analysis tends to be far shorter term in its outlook.
Often technical analysts will build charts from the historic price and volume data collected. These chartists believe that stocks trade to conformity of patterns, and a visual aid such as a chart can spot short term trends, and reversals of price direction. Charts are used to spot strength and weakness at different prices (levels of support and resistance) to give trade g ranges where short term buy and sell orders can be placed. Consequently, charts are often used by short term traders and in particular are a major source of directional indicators for day traders.
Relative Strength Indicator (RSI)
The RSI is a technical indicator of price momentum. It compares the size of recent gains to the size of recent losses to establish oversold and overbought positions. It is calculated using the exponential moving averages of the last 14 days up closing gains and closing losses closes. The formula for its calculation is:
RSI = 100 –(100/ (1+RS))
where RS = 14 day ema of closing gains/ 14 day ema of closing losses.
The RSI will always fall between 0 and 100, a figure above 80 indicating an overbought position, and below 20 indicating an oversold position. For more information see our RSI page.
Moving Average Convergence Divergence (MACD)
The MACD is one of the most followed momentum indicators. It uses a short exponential moving average (ema – the running average over a set period of days, typically 12 days) and subtracts a long ema (typically 26 days) to calculate the MACD. This line is plotted over a period of time on a graph. Then a shorter ema (usually 9 days) is plotted on the same graph as a signal line. The crossing of the MACD by the signal line indicates turning points in the rise and fall of the share price – when the signal moves above the MACD it is considered a buy signal, and when it moves below it is considered a sell. Most commonly a bar graph of volume traded will accompany the MACD to help confirm these trend reversals. More information can be found on our MACD page.
The Fibonacci Retracement
A mathematical sequence known after its founder, Leonardo Fobonacci, is often used in finance. Each number in a Fibonacci sequence is the sum of the two preceding numbers, but the important bit is the quotient of the adjacent numbers, which is about 1.618 (the inverse of which is 0.618). Amazingly, everything in nature seems to be built around this proportion, and for this reason it is often called the ‘golden ratio’.
In the markets, this golden ratio is translated to three percentages: 38.2%, 50% and 61.8%. There are several technical analysis applications for this, but perhaps the most common is the Fibonacci Retracement.
On a graph after a significant move up or down, five lines are drawn. The first is at the high, the second at the low. Between these lines, three further lines, at 61.8% of the difference, 50% of the difference, and 38.2% of the difference are drawn. These lines represent new areas of support and resistance as the stocks retraces its significant move.
Fibonacci multiples are also used by technical analysts to draw Fibonacci arcs, used to anticipate areas where the price will become range bound; Fibonacci Fans, to indicate areas of support and resistance in a longer term trend; and Fibonacci Time Zones to indicate times when significant moves may be experienced.
So, what’s best for you?
What type of analytical process is best for you will depend upon your investment and trading philosophy. It may be that the longer term advantage of looking deep into the fundamentals of a company’s balance sheet will better suit your portfolio, or perhaps you require the short term directional qualities of technical analysis. Some investors will hold a long term position based on company fundamentals, whilst seeking to make further gains by trading around that position and with the ‘noise’ identified by technical analysis and chart patterns.
Whether technical or fundamental analysis is used as a basis of stock and trade selection, you should remember that no one ratio on its own is likely to give a complete picture. Often analysts will consider a whole spectrum of fundamental valuation ratios and technical price graphs before making a buy, sell, or hold recommendation.
Whatever type of investor you are, and whichever style of analysis you prefer, it’s important to remember one thing. Both fundamental and technical analysis depends upon the manipulation of data. If the data is incorrect in the first place, then the final recommendation is likely to be wrong.