To significantly gain from investing in stocks, one has to be equipped with different strategies or approaches. The two main schools of thought any amateur investor needs to be familiar with are fundamental analysis and technical analysis. Each approach has its own advantage. But how do these differ from each other? An investor would want to know which can be the faster way to earn from the stock market. What type of analysis should be used if an investor is looking for a long-term investment? Read through this article about these two major approaches that are used in analyzing stocks and other securities to find out the answers to these questions.
Fundamental Analysis vs. Technical Analysis
Fundamental analysis is a strategy of analyzing a stock investment or any security by determining its intrinsic value. A very important ingredient to this is to look at a company’s financial condition. Other aspects like management, industry trends, and overall condition of the economy are also taken into account. The main objective is to estimate a certain value for a company that can be used as a basis for decision. If the data and information point to a higher value than what is currently being shown in the market, the current pricing of the stock is deemed as undervalued. In other words, there is a room for growth in its value which investors can gain from. A buy is therefore signaled. On the contrary, if the value is lower relative to the current short-term pricing, the company is deemed overvalued, in which the price will tend to decline in the long-term as it tries to correct itself downward.
On the other hand, technical analysis does not look into the value of a stock as a primary motive for buying or selling a stock. It entails studying the trend and momentum in a stock’s price and volume. Based on the trends, traders can determine when to buy or when to sell shares of that stock. Technical analysts mainly use a chart, that is why they are also called chartists, and they do not usually consult the financial conditions of the companies.
While the main objective in fundamental analysis is finding the intrinsic value of a certain stock, that in technical analysis is not but rather finding the right time to enter or exit based on the past and current trend of prices and volume of trade. Both, of course, deal with seeking how to possibly profit from a future rise in prices. Fundamental analysis is for long-term investing while technical analysis is for short-term trading. Fundamental analysis is about investing in companies that an investor thinks has a value greater than what is reflected in the price while technical analysis is about trading stocks, which is buying when the price trend is at a low point and selling when it is at a higher point. If the main tools of fundamental analysis advocates are a company’s financial statement, that for technical analysts are charts. Despite the differences in these approaches, many investors who take a fundamental approach in investing also use technical analysis to determine when to enter or exit the market.
Both methods of analysis take the sentiment of the market in some sense. A person doing technical analysis cares about the supply and demand in the market. Through this, he or she determines which trend will persist in the future. A fundamental analyst, on the other hand, studies the market as well especially the growth of the overall market and the relative position of the company vis-à-vis the market. Does the company try to win a new market, an emerging economy perhaps? How big is this market to the overall market of a particular product or service? If there is no new market created, is the company in a strong position to steal another’s market share? Contrary to technical analysis which looks only about the emotions of the market, fundamental analysis scrutinizes its components.
Fundamental analysis entails a relatively longer time horizon compared to technical analysis. While fundamental analysis usually concerns analyzing data and information that stretch over several years, technical analysis may be used within a matter of days, weeks, or even as short as minutes.
This difference is a result of the investing approach which each relies on. The value of a company, which is the main basis of fundamental analysis, may take a while to manifest in the market and the gain that a so-called value investor is not achieved until the stock price rises to its intrinsic or correct value. Under this method, it is assumed that the market is wrong in the short-run but this gets corrected after a while. This process of correction may take several years. The reason behind the long term horizon is that financial statements which fundamentalists use are filed only every quarter. Data such as revenues and earnings per share do not show up on a daily basis like stock price and volume data. Also, since fundamentals pertain to the actual attributes of companies, various aspects take time to reflect. The results of various activities or adjustment like creation of new products, management change, and boosted supply chains, among others take a long time to realize. A change in the management of the company cannot just employ adjustments overnight. In contrary, technical analysts rely on the daily data on prices and volume and therefore, they can make very quick decisions.
Comparing the Two Stock Analysis Techniques
1. Fundamental Analysis
In fundamental analysis, the key measure used by analysts in selecting a stock to invest in is its fundamentals, which is rather broad because this is comprised of financial strength, industry leadership, and good quality management, among others. Most investors look for companies that have good governance that can be obtained by studying how decisions have paid off in the past. Fundamentalists look for those that are relatively undervalued, have high profitability and increasing revenues from its core businesses, have the ability to pay off debts, and have a significant level of free cash flow including the ability to put it into productive uses, among others. The financial ratios that investors pay attention to include earnings per share (EPS), price-to-earnings ratio (PE/ ratio), price-to-book ratio (P/B ratio), net profit margins, and return on equity (ROE), among others.
EPS is a gauge of profitability. Given two companies with similar earnings per share, the one that is able to produce the same amount of earnings using relatively lower amount of equity or investment money is the more efficient company. Meanwhile, the P/E ratio refers the amount that investors are willing to shell out for each dollar of earnings. While a high P/E ratio signals that investors have high valuation for the company, it can also indicate that the stock is overvalued. In addition to the P/E ratio, investors also use the PEG ratio which is just the P/E ratio but adjusted for growth. Fundamentalists also use the P/B ratio which indicates market expectations of the company’s future earnings. It is often used in combination with return on equity, a measure for profitability. Investors usually look for companies that are able to surpass earnings estimates and those that experience positive revisions in the earnings projections.
Companies that pay safe and growing dividend income are also preferred by income-seeking investors. Therefore, they seek fast-growing dividend payments, high dividend yield, and low payout ratio. A company that has a low payout ratio indicates that despite paying its investors dividend income, it is has a substantial amount left for reinvestment. People give due credit to significant level of free cash flow which is a gauge for the company’s ability to fund its future expansions or acquisitions that can enhance the value of the company.
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In addition, robust industry growth and large market share are also the most sought-after indicators. Even with a relatively low market share if the company demonstrates the ability to expand its market by venturing in emerging markets, for instance, or steal the current market share of other companies. When considering investing in other countries, fundamentalists also weigh the overall condition of the economy and regulatory environment.
2. Technical Analysis
In technical analysis, price trend and volume of shares traded are important metrics. To confirm the price patterns of a stock, technical analysts use volume. Any trend that is coupled with a relatively higher volume indicates a stronger trend than that when the volume is low. For instance, if the price is going down and the volume of shares being traded is high, it is a strong downward trend. If suddenly, a stock has gained 5 percent over one day after being in a sustained downward activity, traders can confirm that this is a real trend reversal if the volume is higher on that day than the average of the past days. But if it is a below-average volume, this does not support a true reversal of the trend. If you are waiting for a sustained upward movement in the price, look for an increasing trend in price backed by higher volume or the upturn may end immediately.
Technical analysis uses two key indicators – leading and lagging where the former goes before price movements which can have predictive power and the latter acts as confirmation tool since it chases a price movement. Meanwhile, buy and sell signals are formed based on two ways – crossovers and divergence. Crossovers are reflected when two varying moving average cross over one another or the price goes through the moving average. Divergence is simply the case when the price trend and indicator trend move in the opposite direction. Such indicator signals a weakening price trend.
One of the most popular indicators of technical analysis is the moving average convergence/ divergence (MACD). It is used to determine the strength, momentum, direction, and even duration of a trend. The MACD is just the gap between the shorter term moving average and the longer term moving average. If the MACD turns in a positive result, it indicates a shorter term moving average that is higher than the longer term moving average suggesting an upward momentum. The opposite suggests a downward momentum. Another tool used is the MACD histogram where the differences between the MACD and the exponential moving average of the MACD, called the signal line, are expressed in bars. The higher bars indicate greater momentum behind a certain direction to which the bars point. If the signal line is below the MACD, buy signals generated. On the other hand, if the signal line crosses above the MACD, sell signals occur.
Technical analysis also uses volume indicators like the accumulation/distribution line. This line indicates the ratio of buying to selling. Furthermore, analysts use the average directional index to determine the strength of a current trend. There is also a relatively new indicator called Aroon indicators which being used to predict when a trend is likely to begin.
Fundamental analysis differs from technical analysis in various aspects which include the nature of participation, main objectives, time horizon, and tools. While they differ in many ways, they both pay attention to market sentiments and seek opportunities to increase the possibility of gaining while reducing the risk of losing. They both seek for moves that have a margin of safety.
Both of these types of analyses have their arguments and there is actually no right answer as to which is the superior one. The choice of an investor depends on the situation and investment objectives and these two approaches can actually co-exist. For fundamental analysts, determining when to best enter the market through technical analysis is very important to achieve great success. On the other hand, if you are a technical analyst, you might want to check some vital fundamental data to reaffirm your decision that is based on some buying signals in the technical trend. Many participants have gained quite remarkably by combining the two. But in the end, what is important is to do the homework and apply the investment philosophy that fits best into your investment plans, preferences, and circumstances.
To end, here is a terrific chart that details the varying differences between the two methods. See which type of investing fits your personality and financial goals.