When approaching investments in the capital market, two methods are prevalent – fundamental analysis and technical analysis.
Which is better – Fundamental Analysis or. Technical Analysis? Which one to go for? Do you read charts and believe in them for investing? Do you make an investment decision based on Financials, Growth, and EPS? Is the technical approach better than fundamentals? Is technical safe for an investor?
These are some of the common questions an investor gets while participating in the market. Also, there are advocates and detractors of each approach.
But there have been different routes for different people, and one strategy doesn’t necessarily fits all. Undoubtedly many individuals find both types of analysis useful for examining market action, and both have a different school of thought.
In this blog, I seek to explain both methods for participating in the market. Before we discuss the advantages, disadvantages of different styles, and their suitability, let us first understand what the strategy behind each technique is.
Also, let us look at the process of the same.
In this article
- What is fundamental analysis
- Technical Analysis
- How is Fundamental Analysis Conducted?
- How is technical analysis conducted?
- Advantages and Disadvantages
What is fundamental analysis
It is the approach whereby an individual tries to compute the intrinsic value of a stock by looking at the fundamental economic factors that are likely to impact the value.
2.Factors important for the analysis
Following are the factors that are important for conducting the fundamental analysis –
- Parameters from Balance Sheet and Profit & Loss – This includes revenues, expenses, and profit
- Growth prospects of the company – This consists of an understanding of the market, product profile, customer profile, concentration, and the likes.
- Competitive factors for the company – This includes an understanding of the competitive landscape of the company, including competitors, market share, barriers to entry, pricing power, etc.
- Expected return on equity or assets – This includes the industry average and is ideally higher than the Sensex (or any other benchmark) returns since inception.
The purpose of this analysis is to establish a value of the stock that would factor in all the underlying factors mentioned above.
The approach doesn’t look at the short-term pricing and doesn’t take into account the short-term trade swings. The plan is for long-term investment as it tends to make time for the intrinsic value to be realized.
In this approach, the factors are forward-looking expectations, and the model is build to arrive at the valuation based on
backward and forward-looking information.
It is the approach in which an individual evaluates investments purely on the market activity surrounding them. The method doesn’t involve looking at the actual operations or value of the company.
2.Factors important for the analysis
Following are the factors that are important for conducting the technical analysis –
- Historical price of the stock
- Historical trading volume
- Industry trading trends
3.Some tools used in technical analysis
There are several tools available in technical such as simple moving averages are indicators that help assess the stock’s trend by averaging the daily price over a fixed period.
Besides, there are few momentum-based indicators, such as Bollinger Bands, Chaikin Money Flow, Stochastics, and Moving Average Convergence/Divergence (MACD).
Each of these unique tools provides buy and sell signals based on their criteria.
4.The goal of the analysis
The purpose of the analysis is to capitalize on pricing opportunities and trends that are identifiable in the market for each share. The methodology is based on the historical price of the stock, historical market activity, past trading volumes to identify the pattern.
How is Fundamental Analysis Conducted?
As seen previously, the fundamental analysis seeks to find the enterprise value of the company. Thus, the approach uses economic factors. While conducting fundamental analysis, the following route is adopted –
- Economic Analysis
- Industry Analysis
- Company Analysis
1.Assumptions in the analysis
Over the long-term, the stock price tends to reach its intrinsic value
Gain can be made by purchasing an under-valued stock and then wait for the market to take it to its real value
The technique is adopted by value investors looking for buy and hold strategy.
2.Steps to carry out the fundamental analysis
Step 1: Perform industry analysis –
An analyst/investor should dig out and find everything about the sector in which the company operates. The study will give output such as –
- Sector growth rate
- Key drivers for growth
- Contribution to the GDP by the industry
- Sector trends
- Demand and Supply analysis
Step 2: Conduct a company analysis
In this step, an analyst is supposed to understand the inside out of the company using different financial tools such as ratio analysis horizontal analysis, vertical analysis, etc.
The study will give output such as –
- Trend evaluation – percentage increase/decrease relative to the base year
- Areas where the company has applied its resources
- Proportions in which the funds are distributed to different heads
- Understanding the changes in the financial situation
Step 3: Conduct financial modeling
In this step, an analyst is required to forecast the future of the company for the foreseeable future, i.e., Three to seven years. An analyst may need a lot of information and assumptions in this step. This may be availed with the help of the management interview.
The objective of the step is to analyze how the financial statements and the stock price will look in the future.
Step 4: Carry out Valuation
There are many techniques for valuation that can be used. Many of the methods are dependent on the type of company and industry. Some of the ways are – Discounted Cash Flow (DCF), Relative valuation (includes Price to Earnings Multiple, Price to Book Value Multiple, etc.), and Sum of the parts (SOTP).
Discounted Cash Flow Analysis
In this method, the analyst arrives at the intrinsic value. The ways and procedures are exciting, and an analyst can always be innovative with the approach. To understand the basics of DCF, click here.
Once, you arrive at the intrinsic share price for the company; the following is the interpretation.
- If Market Price (MP) > Intrinsic Price (IP) = stock is overvalued and the analyst should recommend sell or the investor should sell the stock
- If MP < IP = stock is undervalued, and the analyst should recommend buy, or the investor should buy the stock
Relative Valuation Analysis
In this approach, analyst/investor values the company by comparing it to the peer group.
Following parameters are used in the approach –
- PE Ratio (Price to Earnings Ratio)
- Earnings Per Share (EPS)
- EV/Sales, etc.
How is technical analysis conducted?
Technical analysis, as mentioned above, is a method of evaluating securities. However, in this method, the game is dependent upon the stats generated by the market.
Thus, charts and patterns are the bread and butter for such an approach. Following are the characteristics of technical analysis are:
- Uses past price movement to predict the future price movement
- Trends and Patterns play a significant role
- The market price is the bible
- Fundamental factors may not impact
1.Rules of technical analysis
Following are the three golden rules for technical analysis –
- First Rule: Prices discount information available to the public
- Second Rule: Price movement is generally based on the trend that can be predicted (to some extent) using technical tools
- Third rule – Price Trends are likely to repeat themselves
2.Steps to carry out the technical analysis
Step 1: Identify the security that interest you
Basic research on trending sector shall help an analyst/investor (trader) to decide on the stock to buy or sell.
Step 2: Identify the strategy
Remember, one approach doesn’t fit all the stocks, and thus you must have variation based on the share, its characteristics.
Step 3: Select the right trading account
This step is essential to ensure that the brokerage or the charges involved are within your budget and are reasonable.
Step 4: Understand the tools and interfaces
An analyst/investor (trade) is supposed to select the tools that fit your trading requirements and strategies. You can always check the web for freely available tools.
Step 5: Conduct trade on simulation first
While making investments by technical approach, an investor should first try their strategy on the selected stock with the help of a simulation tool or tools such as excel. Once the testing of the approach is conducted, only then you should shift to trade with real money.
Step 6: Always have a stop loss
A stop-loss allows you to cut on your losses automatically if the stock moves opposite than anticipated. This helps in holding a losing trade. Having a stop loss enables an investor to remain disciplined.
Advantages and Disadvantages
- The methods used in the fundamental analysis are based on financial data and thus eliminates room for personal bias.
- The approach considers long-term economic, demographic, technologic, and, consumer trends.
- The analysis has a systematic approach with different statistical and analytical tools that help in arriving at the final Buy/Sell recommendation
- Rigorous accounting and financial analysis allows an investor to gauge a better understanding of the company and its practices
- Conducting industry analysis, valuation is not everyone’s cup of tea and needs a good amount of hard work, patience, and time.
- Assumptions play a vital role in forecasting financials. Thus, things may go wrong if the assumptions are not rationale.
Following are the benefits of the approach –
- Provides insights on volume – It goes on without saying that demand and supply govern the market dynamics. Thus, knowing the volume helps you gauge how the overall market works.
- Tells about the entry and exit points with the help of charts and patterns
- Provides Current Information – Price reflects information about an asset
- Patterns give a directional view and act as a guide to direct your buy and sell decisions.
- Many indicators often spoil the chart thereby by producing confusing signals that may affect the analysis
- Fundamentals remain ignored – The approach does not take into account the underlying fundamentals of a company. This can prove risky over the long-term.
Which approach is suitable for you?
Trading style and attitude go in sync. Your attitude helps you understand what kind of investment approach will suit you. Often investors are seen combining both these approaches and ending nowhere.
When it comes to choosing between the two, several factors should be considered –
- Time horizon is essential to consider – Fundamental analysis is a long-term strategy, whereas technical analysis is more short-term in nature.
- Understand your investment approach – Are you an investor or a trader? Fundamental analysis is investing in the business because you believe in the product/service and believe the price to reach its intrinsic value over tie. On the other hand, technical analysis is a trading strategy where you seek to drive returns out of identified trends and opportunities.
- How much time you can give – Trading needs active time and management on the part of the investor. On the other hand, the fundamental approach asks for patience.
If you ask an individual, which one he/she would prefer – the majority of them would say a combination of both as the best way. Both the approach has its pros and cons and are suited to different types of individuals. A combination of both can work too provided the capital invested in both remains segregated and is not interchanged.
Irrespective of what you choose, you should always remember the following two rules from ace investor Warren Buffet –
1 – Never Loose Money
2 – Never forget rule 1
Disclaimer: The views expressed in this post are that of the author and not those of Groww