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Technical and fundamental analyses are techniques employed by investors and traders to analyze the current situation and prospects of different financial instruments.
These two approaches analyze different variables to determine if the financial asset could experience a positive fluctuation in the future. They can also point to a negative outlook in some cases.
Understanding these two techniques will help amateur investors in enriching their investment skills and, upon reading this article, you will know the basics of how both of these approaches work and how you can apply them to analyze different financial instruments.
What Is Fundamental Analysis?
The goal of fundamental analysis is to determine the intrinsic value of a certain financial instrument upon assessing certain qualitative and quantitative factors.
For stocks and bonds, most of the information used to perform a fundamental analysis comes from the issuer’s financial statements. However, other sources, including industry publications and market research reports, may also be used to assess the competitive situation of the company and its prospects.
On the other hand, for bonds, fundamental analysis can also be performed by using certain basic formulas to determine the fair value of the asset upon assessing its future cash flows and the creditworthiness of the issuer — among other factors.
Benjamin Graham is considered the pioneer of fundamental analysis. This Wall Street legend wrote the book called “Security Analysis” back in 1934. The techniques he outlined back then for valuing financial instruments remain the foundation of today’s practices.
Pro Tip: In a nutshell, fundamental analysis is a startegy used by investors to determine a stock’s real or “fair market” value.
Fundamental Analysis Tools
Both quantitative and qualitative variables are analyzed when trying to assess the value of a financial instrument using fundamental analysis. The following is a short list of the most common ones.
Qualitative fundamentals refer to the aspects of the business that cannot be quantified but that still play a role in shaping their financial performance over time.
The business model of a company refers to how it generates money. It explains who its top suppliers and customers are, which channels it uses to distribute its products and services, and how much it charges.
There are many different business models including retail, wholesale, subscription, franchise, software-as-a-service (SaaS), etc.
Understanding the business model of a firm is crucial to determining how it has made money in the past and how it plans to keep producing revenues in the future.
A competitive advantage is a unique aspect of the firm’s value proposition that is not offered by its rivals. It sets the business apart from the competition and makes it more appealing to its customers.
The more competitive advantages a business has, the better. Moreover, if those advantages are difficult to replicate, the business will be more valuable for investors as it will have what is known as “a competitive moat”.
The leadership team of a company is essential for the adequate execution and achievement of its long-term initiatives and goals. For this reason, analysts pay close attention to who makes up this important team. Analysts typically looks into the management’s track record in previous jobs and what they have done for the company since they came on board.
Another great way to analyze the senior management’s performance is to look at their promises and claims from five to 10 years ago to see if they have lived up to these expectations.
All businesses depend and perform to some extent based on how macroeconomic factors of their respective domestic economies evolve. For this reason, a fundamental analysis also takes a look at the current economic conditions to assess the business’s valuation.
Some of the most important variables that analysts keep an eye on include prevailing interest rates, gross domestic product (GDP) growth, and inflation. These, among other factors, could have a sizable effect on a company’s performance in the future.
Financial statements and operating metrics are typically interpreted by analysts to determine the fair value of a company. These are some of the most common metrics that are typically used to assign companies a price tag.
The balance sheet of a business portraits its current financial condition. It includes a detailed breakdown of its assets, liabilities, and equity. A business with an elevated level of debt is perceived as riskier from a fundamental standpoint. On the other hand, the composition of a firm’s assets also plays a role in shaping its valuation.
For example, companies that are top-heavy in their balance sheet are considered more liquid and less risky than those that have a large fixed asset base as the latter group will be more sensitive to suffering impairment charges.
The income statement of a company reflects its financial performance during a certain period — typically a quarter, a semester, or a fiscal year. This statement breaks down how much the company generated in sales during that time frame and progressively deducts the different expenditures that occurred during the period.
This statement is typically analyzed to determine a firm’s profit-generation capacity while it could also be compared historically to analyze trends and sudden changes in the composition of the firm’s cost structure.
The more predictable a company’s performance has been, the easier it should be to forecast how it should perform in the future.
Cash Flow Statement
The cash flow statement shows how much of the company’s earnings have turned into an increase in its cash balance. This statement adds back all non-cash expenditures and deducts all cash payments that affect the balance sheet to illustrate if the company has produced or burned its cash reserves during a certain period.
For analysts, a company’s cash flow generation capacity is a great indicator of its financial profitability. One popular metric that is often used when performing fundamental analysis is the free cash flow metric.
This figure deducts essential capital expenditures from the firm’s net operating cash flow to understand how much money the company is producing to finance future investments or to distribute some of its profits to its shareholders.
Price-to-Earnings (P/E) Ratio
The price-to-earnings ratio uses data that can be easily obtained to estimate how many years it would take an investor to fully recuperate his/her investment in a stock if earnings remain unchanged. The higher the P/E ratio, the longer time it would take the investor to get his money back.
As a rule of thumb, low P/E ratios (below 25) tend to be associated with potentially undervalued businesses while a high P/E ratio (above 25) tends to be associated with overvalued companies. However, other factors also play a role in shaping the trading multiples of a business aside from earnings alone.
Price-to-Earnings-to-Growth (PEG) Ratio
The price-to-earnings-to-growth (PEG) ratio was coined by the famous investor Peter Lynch. It seeks to smooth the inherent flaws of the P/E ratio by incorporating the company’s historical or forecasted earnings growth into the mix.
In summary, a PEG ratio below one signals that a company is fundamentally undervalued while a PEG ratio above one indicates that the firm is overvalued based on its past or future earnings growth. Meanwhile, a ratio equal to one indicates that the business is fairly valued.
Debt-to-Equity (D/E) Ratio
Aside from earnings alone, fundamental analysis also focuses on certain components of the balance sheet — the most important being the firm’s debt. The debt-to-equity (D/E) ratio measures how leveraged a business is by expressing how many dollars of debt it holds per every dollar invested by its shareholders.
A conservative D/E ratio would usually be below one, meaning that there is $1 in debt for every $1 invested by shareholders. Lower ratios may have a positive impact on the firm’s valuation as they would make the company more stable even under the most challenging economic scenarios.
That said, certain businesses — i.e., capital intensive companies — will always have high D/E ratios due to the nature of their operations. For this reason, another way to assess if a business is highly indebted or not is to compare its D/E ratio with the average of its industry or peers.
Profit Margins & Return on Equity (ROE) Ratio
A company is only as valuable as its ability to generate profits for its shareholders. Therefore, the higher its profit margins, the higher the valuation that a business will obtain from prospective investors.
In this regard, there are multiple profit margins that investors tend to analyze to assess a business’s value from a fundamental standpoint. These include:
- Gross margin
- Operating margin
- EBITDA & EBIT margins
- Net margins
There are also adjusted versions of these margins that deduct non-recurring or non-cash items such as shareholder compensation and losses from discontinued businesses.
Moreover, investors can also assess the profitability of a company by measuring the percentage that its net income produces for every dollar invested by shareholders. This ratio is known as the Return on Equity (ROE) ratio and the higher it is, the more profitable the business is.
Fundamental Analysis Pros
- It helps investors in determining the fair price (intrinsic value) of a business.
- It provides an objective measure that can be used to determine if market prices are attractive or not.
- It incorporates both qualitative and quantitative variables.
- It can be used for multiple financial assets.
Fundamental Analysis Cons
- It will require some guesswork to estimate the future path of a company’s profits.
- The past performance of a business does not guarantee future results.
- It requires extensive accounting and corporate finance knowledge, especially if the business is large and complex.
What Is Technical Analysis?
Technical analysis is a technique that employs price and volume data to determine if the price of a financial instrument is poised to go up or down. The tools used for performing this kind of analysis include chart patterns, price or volume-derived indicators, and trend analysis.
Technical analysts can interpret data from different time frames going from multi-minute or multi-hour (for day traders) to multi-day or multi-week (swing traders).
Pro Tip: In a nutshell, technical analysis is a resource used by traders to research and evaluate investment opportunities utilizing price trends and patterns seen on charts.
Technical Analysis Tools
The toolbox of a technical analyst is quite extensive and even the most sophisticated traders come up with indicators to try to assess the direction that the price of a security will take in the future. The following is a summary of the most common ones.
A trend indicates the direction that the price or volume of a security has taken in the past and it is used to predict the direction that it may continue to follow in the future.
An uptrend refers to a price or volume chart that shows a series of subsequent higher highs. Meanwhile, a downtrend is a chart formation that displays a series of subsequent lower lows in the price.
Most traders prefer to “trade with the trend,” which means that they would rather follow the overall direction of the price or volume action rather than go against it.
Volume and Momentum Indicators
Volume indicators use this data to determine if a stock is experiencing positive momentum. High volumes during positive sessions tend to signal that bulls have taken over the price action while high volumes during negative sessions tend to signal the opposite.
Volume indicators such as the volume profile can also be used to assess which prices have seen the highest trading volumes. These prices are typically highly contested and a break above or below them could be interpreted as a buy or sell signal.
Meanwhile, momentum indicators are designed using historical prices (moving averages or exponential averages) to determine when the current directional trend of a stock is accelerating.
Moving averages collect information from the past to possibly predict the future of either the price or volume of a financial instrument. There are simple and exponential moving averages. The former is just the sum of the prices of the last however many days divided into that same number while the latter puts more emphasis on the most recent data as it is considered more relevant.
The most common moving averages used by traders are the seven-day, 20-day, 50-day, 100-day, and 200-day simple and exponential moving averages.
Support and Resistance Levels
Support and resistance areas are price levels identified within a chart that show strong selling areas (resistances) and strong buying areas (support).
A support area is one where investors become highly interested in the instrument and buy it accordingly. Meanwhile, a resistance area is a price level at which investors are willing to sell or short-sell the asset as they anticipate an upcoming decline in its price.
Oscillators are technical indicators whose value is derived from past price or volume data. They are designed to provide buy or sell signals to traders. The Relative Strength Index (RSI) and the MACD are among the most frequently used oscillators.
The RSI, for example, tells traders if a stock is overbought or oversold based on its latest price action. In theory, an overbought stock is poised to decline as market participants have pushed the price too high too fast while the opposite can be interpreted if the oscillator enters the oversold area.
A pattern is a formation that can be identified in a price chart. There are simple patterns such as price channels and more complex setups such as the head and shoulders or cup and handle patterns.
These patterns were designed to easily interpret what the price of an asset is doing within a certain time frame to possibly predict the direction that it will take in the future.
One example is the head and shoulders pattern, which consists of a first high (first shoulder), a subsequent higher high (head), and a lower high (second shoulder). The pattern also identifies a neckline, which is a support area from which the price has bounced throughout the process of posting these three key highs.
In practice, this pattern tells the trader that bulls have exhausted their ammo upon pushing the price to the highest high (the head) and now bears are taking over – hence the second shoulder. Once the neckline has been broken, the pattern is considered confirmed and a sharp decline should follow as the bulls should capitulate.
Technical Analysis Pros
- It can be used to determine the best entry and exit prices for a particular instrument.
- It illustrates, to some extent, the market’s sentiment toward the instrument.
- It uses objective data (price and volume) to predict the future directional path of the asset.
Technical Analysis Cons
- It can be complicated to interpret unless the analyst has been appropriately trained.
- Regardless of their complexity, no indicator or pattern is infallible.
- It does not take into account the fundamental aspects of the underlying asset.
What Are the Differences Between Technical and Fundamental Analysis?
- Technical analysis focuses on price and volume data while fundamental analysis relies on financial statements and market research reports.
- Technical analysis is typically used for short-term trading strategies while fundamental analysis is mostly employed by long-term investors.
- Fundamental analysis seeks to determine the fair value of a business while technical analysis aims to determine the future direction that the price of an asset may take.
- Technical analysis focuses on past data while fundamental analysis also incorporates an assessment of future projections.
Who Is Technical Analysis Best For?
Technical analysis is typically used by traders and investors who have relatively short investment horizons — often known as swing traders or tactical investors. That said, long-term investors could rely on technical analysis to identify the best time to enter a stock — for example, if it has recently bounced off a key support area.
Who Is Fundamental Analysis Best For?
Fundamental analysis is better suited for investors with a mid to long-term investment horizon. However, determining if a business is undervalued at a given point does not guarantee that the market will rush to correct its mistake — or that such assessment is necessarily right.
Therefore, long-term investors who use fundamental analysis must be patient to wait until the market either validates or rejects their thesis. That could take months, years, or, in some rare cases, decades.
Even though investors and traders have discussed for decades which of these two approaches is better, as with many things in life, neither is necessarily better than the other — they are just different.
Depending on what role you plan to take when participating in the financial markets — trader or investor — you may pick among these two techniques accordingly or you may use them in combination to strengthen your investment thesis.
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Alejandro is a financial writer with 7 years of experience in financial management and financial analysis. He writes technical content about economics, finance, investments, and real estate and has also assisted financial businesses in building their digital marketing strategy. His favorite topics are value investing and financial analysis.