Analysis is an important part of investing. In this post, we will discuss two approaches namely Fundamental and Technical Analysis used for analyzing stocks.
Fundamental Analysis
First of all let’s understand what the word fundamental means. The word fundamental means forming a necessary base or core; of central importance. Fundamental analysis involves understanding the company from the core of its business. It involves examining a company’s financial statements and broader economic indicators to uncover a security’s true worth.
Factors under consideration in Fundamental Analysis:
Company Financials:
- Revenue growth: Whether the revenues of the company are growing or not? whether it is consistent or not.
- Profitability: Whether the company is making profits consistently? If there is a deviation in profits or reduction in profits what are the reasons?
- Competitive advantages: How good is the business model and product of the company as compared to its competitors? What is the MOAT of the company as compared to its competitors?
- Management effectiveness: How good is the management with understanding the challenges and steering the company out of it in the right direction?
Macroeconomic Factors:
- Overall economy: How is the overall economy doing both domestically and globally? Is there a slowdown in demand?
- Demand for products/services: How good is the demand for the company’s products/services? How good is the brand value of the company?
- Industry trends: How good is the Industry doing as a whole? What are the future prospects of the industry? What is the growth rate of the industry?
Key ratios in Fundamental Analysis:
- Price-to-Earnings (P/E) ratio: Compares stock price to earnings per share (EPS). A high P/E may indicate overvaluation.
- Return on Equity (ROE): Measures profitability relative to shareholders’ equity.
- Debt-to-Equity (D/E) ratio: Evaluate a company’s debt burden.
Other ratios include price-to-sales (P/S) and price-to-book (P/B). If you want to read more about Financial Ratios you can read about them here.
Limitations of Fundamental Analysis:
Fundamental Analysis is essential for the proper analysis of a company for long-term investment. It has some limitations as described below:
- Time-Consuming: Analyzing financial statements, economic conditions, and other relevant data requires time and effort. Not suitable for those who are pressed for time or seeking quick trading decisions.
- Subjectivity: Interpretation of financial data can be subjective. Different analysts may arrive at varying conclusions based on the same information.
- Limited Application: Fundamental analysis is primarily applicable to the stock market and bond market. not suitable for other assets or securities lacking financial data and relevant economic factors.
Common mistakes in fundamental analysis:
- Overreliance on Economic Indicators: While economic indicators like GDP growth, inflation rates, and unemployment figures are essential, don’t rely solely on them. Consider other factors like market sentiment and geopolitical events.
- Ignoring Market Sentiment: Fundamental analysis should account for both objective data and subjective market sentiment. ignoring the latter can lead to misjudgments.
- Failing to adapt to changing conditions: Markets are dynamic. be flexible and adjust your analysis as conditions evolve. what worked yesterday may not work today.
- Neglecting Risk Management: Fundamental analysis informs your investment decisions, but risk management is equally critical. Don’t overlook position sizing, stop-loss orders, and risk-reward ratio.
- Lack of Patience and Discipline: Fundamental analysis requires patience. Avoid impulsive decisions based on short-term fluctuations. Stick to your strategy.
- Failing to Consider Multiple Perspectives: Seek diverse viewpoints. Don’t get trapped in a single narrative. Consider alternative analyses and opinions.
Fundamental analysis helps us assess the business of the company and its future prospects and check if the company is undervalued or overvalued based on its current and projected worth.
Technical Analysis
Technical analysis is a powerful tool used by traders and investors to evaluate securities and identify trading opportunities. Let’s first understand what Technical Analysis means.
What is Technical Analysis?
This involves analyzing historical market data (such as price movements and trading volumes) to predict future price movements. It uses insights from market psychology, behavioral economics, and quantitative analysis. Technical analysts study trends, chart patterns, momentum indicators, and other factors to make informed trading decisions.
Key aspects of technical analysis:
- Price Trends: Analyzing price charts to identify patterns (eg. head and shoulders, triangles) that suggest potential price movements.
- Volume: Examining trading volume alongside price changes to gauge market strength.
- Indicators: Using tools like moving averages, RSI (Relative Strength Index), MACD (Moving Average Convergence Divergence), and Bollinger Bands for predicting stock price movement direction.
- Support and Resistance Levels: Identifying Key levels where prices tend to reverse.
- Candlestick Patterns: Studying candlestick formations for insights into market sentiment.
Limitations and Assumptions:
- Short-Term Focus: Technical analysis is often used for short-term trading signals.
- Market Efficiency: Assumes that all relevant information is reflected in prices.
- Behavioral Biases: Acknowledges that investor behavior can influence price patterns.
Application:
- Securities: Technical analysis can be applied to stocks, futures, commodities, currencies, and more.
- Complementary approach: Many analysts combine technical analysis with fundamental research for a holistic view.
While technical analysis provides valuable insights, it’s essential to consider other factors and use them in conjunction with your overall investment strategy.
Fundamental Analysis vs Technical Analysis
- Fundamental analysis focuses on intrinsic value, financial health, and long-term potential. Technical analysis studies historical price trends for short-term predictions.
- Fundamental analysis helps you see beyond market sentiment and marketing hype, revealing a company’s true potential. The goal is to understand the business of the company. Technical Analysis helps in predicting the price trends for finding the right opportunity to buy or sell the stock.
- Fundamental analysis is used for making long-term investment decisions based on the business model and management competence, while Technical Analysis is used for taking short-term positions in the stock and can’t predict the long-term outcome of the stock with any fundamental backing.
Conclusion
So what should you be using?
If you are an investor who likes to take bets on businesses and management of the company you should perform fundamental analysis. Fundamental Analysis helps investors to identify multi-baggers based on business model, product position, innovation, and management competency.
Technical Analysis is used by traders for taking positions in the market on stocks to benefit from the volatility in the market. However, Technical Analysis can be used post-fundamental Analysis to buy the selected stock at discounted prices by figuring out dips through technical analysis.
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