Fundamental Analysis vs Technical Analysis – that will be the topic of today’s article.
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Table of Contents
Did you ever come across the terms like fundamental analysis or technical analysis? Are you seeking an efficient explanation so that you can understand them easily?
Don’t worry. I hear you. Sometimes in our lives, we come across new terminology that is hard to understand.
Especially when you are new to the trading realm, such terms can create a lot of confusion.
I am going to explain these in such a way that even complete beginners can understand.
So, if you are hearing about the words you already know, just hang on till you get to the good part.
Let us begin.
What is fundamental analysis?
Well, for beginners, fundamental analysis is the process of finding the intrinsic value of a security. This is done by examining the relevant financial factors and economic factors.
Wait? You heard something about the intrinsic value of securities, right? What is an intrinsic value?
You might have already heard the term security, but for those who don’t know, it is a financial instrument. Financial instruments or assets are something that can be purchased, sold or traded for making money.
Stocks, bonds, investment funds, ETFs, etc., can be considered. As the best examples for securities.
Keeping all that aside, what is an intrinsic value? Why would anyone want to find that intrinsic value?
Intrinsic value means refers to the worth of an asset or financial instrument. You should remember that the market value of an asset will not be the intrinsic value.
Nevertheless, when you compare the current value with the intrinsic value, you can determine the price. Regarding whether it is overvalued or undervalued.
With stocks or companies, intrinsic value is calculated on the basis of cash flow.
But for instruments like Options, intrinsic value is the difference between the strike price and the current price. A strike price is a price where the call or put options can be utilized.
Intrinsic value can also be called fair value or fair market value.
Back to the fundamental analysis now.
Now you understand that the intrinsic value depends on the asset’s financial worth and the current market worth. Fundamental analysis allows you to find the intrinsic value through the current market conditions, i.e., the economic and financial conditions.
With fundamental analysis, you are examining a business at its fundamental level. By considering the key ratios of an asset or instrument, we can find its financial health.
When talking about stocks, you can find a stock’s trade value compared to its rivals through fundamental analysis.
Various key factors are taken into consideration during fundamental analysis such as:
— Future growth
— Profit margins
— Return on equity
The analysts who use fundamental analysis are called fundamental analysts. Such fundamental analysts can find the security’s value from macroeconomic factors and microeconomic factors.
Macroeconomic factors are the factors that are related to the economy. Certain examples include inflation, gross domestic product (GDP), interest rates, etc.
Microeconomic factors are much more focused towards a particular population or business decisions. Supply and demand, taxes, etc., can be good examples. The main objective of fundamental analysis is to find a value. This value can be compared with the current price to know whether the instrument or asset is undervalued or overvalued.
Let us see an example to look at how an asset is deemed as undervalued or overvalued.
Fundamental analysts try to find stocks being traded at prices either higher or lower than their real value. If the fair market value is higher than the stock’s market price, then it is said to be undervalued.
Simultaneously, if the fair value is lower than the market price, then it is said to be overvalued. Undervalued stocks are considered the best to buy and overvalued stocks are recommended to be sold.
Fundamental analysis, in general, is done from a macroeconomic perspective to a microeconomic perspective. This will help the analysts find the assets that don’t have a correct price as per the market.
This begins with the economic conditions such as the well-being of the economy.
Following that, the next step is to focus on the specific industry relevant to the instrument or asset.
Finally, it comes to the financial situation of the specific asset. For instance, the financial situation of the company issuing shares.
In this manner, the fair market value of an asset is determined. However, there are many ways for calculating the intrinsic value of stocks. Whereas for instruments like Options, a standard calculation is utilized.
How is it done?
The publicly available financial data is utilized for finding the value of an asset with fundamental analysis.
Such data can be obtained through financial statements, annual reports and filings.
In the United States, businesses are required to file reports with the SEC (Security Exchange Commission). If you are in the US, there are three important filing forms you should be familiar with.
• Form 10-K
• Form 10-Q
• Form 8-K
10-k is an annual report, 10-Q is a quarterly statement, and 8-K refers to the major events that take place in a company.
Where can you find such public information about a company? Almost all companies provide these details on their websites (investor relation sections).
Importance of Earnings
Among all the data being considered during fundamental analysis, a company’s earnings play a key role.
In simple words, you must try to find the details of the company’s income. Adding to that, find out how much more it can make in the future.
Earnings, as you know, are profits earned by a company. They can be hard to calculate. But the reports, which we discussed earlier, help us do so.
If you see a company doing well, then you can expect a rise in the company’s stock value.
Nonetheless, the companies offering dividends might increase their dividends.
In such a scenario, you may not see a significant improvement in the company’s earnings. This may lead to a decrease in a stock’s value.
By the above example, you might have understood earnings aren’t everything for fundamental analysis.
There are some other efficient tools that help you determine how the market values a stock. By tools, I mean ratios.
Most finance websites have all the information related to these ratios already available.
Yet, it is not too difficult to do it by yourself if you intend to. Let us have a look at some of the important fundamental analysis tools.
Earnings per share (EPS)
You cannot find out much about a company by just finding out about just the earnings or shares.
These two combined will provide you with a frequently used ratio for fundamental analysis.
This is known as EPS (Earnings Per Share) and lets us know how much profit is assigned to each stock.
To calculate the EPS, you’ll have to divide the net income by the number of outstanding shares. While doing this, you must not include the dividends on a preferred stock in the net income.
Price-to-earnings ratio (P/E)
It could have been much easier to understand if it was written as P/EPS.
This is the ratio of the current price of a company’s share with respect to its earnings per share.
Price-to-earnings growth (PEG)
This refers to the anticipation of the earnings growth rate of a stock for a period of one year.
Price-to-sales ratio (P/S)
This is the ratio of a company’s stock price in relation to its revenues. Sometimes, P/S is also known as sales multiple, revenue multiple, or PSR.
Price-to-book ratio (P/B) or Price-to-equity ratio:
This ratio creates a comparison between a stock’s book value and the market value.
This is calculated by dividing a stock’s recent closing price by the previous quarter’s book value of the share.
Book value is the cost of an asset while excluding cumulative depreciation.
Dividend Payout Ratio
This is a comparison between the dividends to the shareholders to the company’s net income.
The yearly dividend total compared to the share price is known as a dividend yield.
To calculate this, you have to divide the dividend payments per share in one year by the value of a share.
Return on equity
Return on equity is found when you divide the company’s net income by shareholder’s equity. This is also called a company’s return on net worth.
That’s most of what is necessary to have a complete understanding of fundamental analysis.
Now let us have a detailed insight into technical analysis.
We have discussed fundamental analysis. We also discussed how it helps in various ways to determine whether an asset is a buy or sell.
Now, we will talk about another way of determining the buy or sell position of an asset. This is Technical Analysis.
To make it very simple to understand, technical analysis is about researching past movements. The objective of researching past price movements is to make a prediction about future price movements.
Charles Dow is the person who created the concept of technical analysis. Don’t recognize him? He happens to be the founder of the Dow Jones Industrial Average and The Wall Street Journal.
Fundamental analysis is the analysis made by considering the corporate dynamics like business structure. On the other hand, technical analysis utilizes price and volume data to anticipate future prices.
Technical analysis uses different types of price charts to analyse the price and volume. Upon the analysis, technical indicators are obtained, which predict whether it is a buy or sell.
The first concept of technical analysis is based on is that the market actions are held accountable for everything. This depicts that a stock’s price reflects the information of a stock’s value.
When anything new happens, which would affect the value of a stock, it is grasped by the market and reflected in the stock price. Another concept of technical analysis is that the prices act in accordance with trends.
This means that the prices will continue moving in a particular direction until a technical indicator suggests otherwise. There is an availability of various technical indicators, and the one to choose depends on the investor.
The concept is to recognize and follow a trend until there is a sign of reversal. If the price is rising and a technical indicator suggests a fall, then a technical analyst investor will sell it.
Another important concept of technical analysis is that historic patterns repeat. I mean the historic patterns that are related to an asset’s price movements. This concept concentrates on market psychology to determine price patterns.
Market psychology refers to the sentiment felt by all investors. They believe that the security prices rely on this market sentiment, regarding ups and downs. Having known about technical analysis, let us now know what technical indicators mean.
Technical indicators are to technical analysis just like fundamental analysis tools are to fundamental analysis.
In simple words, these are the signals based on the price, volume, and interest of a security.
Technical indicators are used by technical analysts, who are also called chartists or technicians.
Such technicians use these indicators to analyse the price movements of an asset.
Common terms of technical indicators you’ll often hear are provided below.
Money Flow Index
Money Flow Index (MFI) is an indicator used to calculate the buy or sell state of an asset.
It makes the analysis on the basis of the time and price of that security.
The money Flow Index can also be referred to as volume-weighted RSI. What is RSI? We’ll get to that.
The MFI index usually swings between the range of 0 and 100. When the MFI increases, then it is considered a signal that the buying pressure of that asset is increasing.
Whereas a negative swing in the MFI would generally mean that the selling pressure is increasing.
An MFI over 80 means an overbought situation, whereas below 20 would mean an oversold condition.
Overbought conditions represent a soon-enough decline and oversold conditions predict a hike.
Moving Average Convergence Divergence (MACD)
This indicator helps a trader identify a trend’s direction and its momentum.
If MACD is more than zero, then the price is expected to increase, and vice versa.
This indicator comprises two lines, which are a MACD line and a signal line.
If MACD falls below the signal line, the price of a security is falling. If it is going above the signal line, then the price is increasing.
Relative Strength Index (RSI)
Like the MFI, the RSI also moves between 0 and 100. This indicator is used to mark recent price gains versus recent price losses.
The RSI is used to determine the overbought and oversold condition.
If the RSI goes below 30, it is oversold, and if it goes above 70, then it is overbought.
Overbought conditions mean that the asset could decline and oversold conditions indicate a hike.
Remember that we said MFI can also be said as volume-weighted RSI, right? That is because the MFI also concentrates on the volume.
This refers to the simple moving average of the number of shares traded within a given period.
If the recent volume is more than the moving average volume, it indicates a greater strength of the trend.
This would indicate the buy condition to the trader. Anyhow, if the recent volume is lower than the moving average, then it indicates a sell.
Bollinger bands are also used to determine the overbought and oversold conditions.
There will be three bands in this indicator, which are the upper band, the average band, and the lower band.
The upper band represents a positive signal whereas the lower band represents a negative signal.
The middle band is the simple moving average for a 20-day period.
If the middle band keeps touching the upper band, then it indicates an overbought condition.
If the middle band keeps touching the lower band, then it indicates an oversold condition.
This indicator is used to measure the positive and negative flow of volume of a security in a given time.
The indicator is based on a total of the volume that went up minus the volume that went down.
The volume that went up is the volume of an asset when its price increased.
The volume that went down is the volume of an asset when its price decreased.
The volume is added to this indicator when there is a hike in the price of a security. The volume is subtracted when there is a decrease.
If the OBV is increasing, then it indicates that buyers are enthusiastic about the security.
Similarly, when the OBV is decreasing, the traders are not too interested in that security.
This indicator is used to calculate the money flow, whether it is in or out of a security.
The A/D line is somewhat similar to the OBV, but there is one major difference. The difference is that the trading range is also taken into consideration along with the closing price.
If the A/D line is trending upward, then it means that the buyers are more interested. This is called an Uptrend.
If the A/D line is trending downward, then it means that the traders are selling. This is called a Downtrend.
Average Directional Index (ADX)
This indicator is used to calculate the strength and momentum of a trend. If the ADX is more than 40, then there is a scope for a lot of directional strength.
This can be up or down. Whether it goes up or down will depend on the direction in which the price is moving.
If the ADX is lower than 20, then the trend is said to be weak or non-trending.
Now, you know about technical analysis as well. The fundamental analysis tools or technical indicators may have been a bit hard to understand.
Yet, I strongly hope that you were able to understand the main definitions easily.
Fundamental analysis is mostly used by individuals who opt for a long-term investment.
On the other hand, technical analysis is said to favour those who are into short-term investments.
Each has its importance. There are some people who believe in one concept while completely being against the other.
I do not want to indulge in the conversation as it would be offensive to those who think otherwise.
The main objective of this article is to provide educational information rather than pick a winner.
Having said that, I hope you were able to understand these topics in a detailed manner.
If you are a beginner, then it is not wise to begin trading/investing by just learning this information.
Investing is a process that requires a lot of focus, time, and effort. Especially when you are involved with certain risky investments, the chances are likely for you to lose money.
Therefore, before getting involved with the process of investing, I recommend seeking investment advice.
A financial expert will guide you on the right path so that you can have a prosperous financial career.
Are you looking for someone who can efficiently take care of your investment needs?
Do you need a financial planner or a wealth manager to deal with your requirements?
Don’t worry. I can be of help. I have helped many people dealing with financial difficulties.
Especially those who wanted to attain financial freedom by overcoming financial difficulties.
If you also need similar services, then do not hesitate to contact me.
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