FUNDAMENTAL ANALYSIS VS TECHNICAL ANALYSIS
Two trains of thought have traditionally dominated investment analysis. On one end of the spectrum is fundamental analysis, dominated by financial statement analysis and the like. On the other end are the chartists and oscillators associated with technical analysis. Indeed, the long-lasting debate in investment and securities analysis has been centered on the relative benefits of each category of research. The focus of this paper will examine the various characteristics that make both fundamental and technical analysis unique. Moreover, for the purpose of this report, equities will used as the chosen security.
1) Fundamental Analysis
Fundamental analysis of equities is the process of determining a stock’s “fundamental” value by analyzing all material information. Fundamental analysis places a particular emphasis on financial statements and other accounting information. As such, fundamental analysis strives to find the enterprise value of a company as measured by its intrinsic value. At its core, fundamental analysis suggests that past price action has no bearing on the future price of a stock. Indeed, fundamental analysis is considered forward looking, despite the fact that the majority of information used in the analysis is derived from historical data. Rather, fundamental analysis assumes that the value of a company is derived from the underlying conditions of the company itself, as well from the macroeconomic setting. Fundamental analysis provides the tools needed to ascertain the underlying value of securities in order to determine whether such securities are undervalued or overvalued. Moreover, fundamental analysis can be applied to any and all securities including stocks (valuation), fixed income (credit risk), and commodities (supply & demand). The following sections will explore a number of the key characteristics associated with fundamental analysis and investing.
Earnings represent the key element that most fundamental investors use for valuating a firm. Before one can invest in a firm, they must first know whether the company has generated any profit. Moreover, investors are concerned with a company’s prospects for future earnings. Future profits represent a firm’s potential for growth, and ultimately stock price appreciation.
There are a number of factors that will determine the earnings of a firm. Those factors include revenue, expenses, assets, and liabilities. Fundamental analysis usually focuses on a firm’s earnings per share (EPS). Earnings per share represents the amount of profit generated for each share outstanding.
1.2) Profit Margins
The shear dollar amount of earnings does not always provide the clearest depiction of a firm’s financial condition and prospects for growth. For instance, while earnings are certainly important, improved profit margins can be seen as an indicator of firm’s future profitability. Conversely, a declining profit margin represents costs growing at a faster rate than revenue. Profit margin represents the amount of earnings a company generates from each dollar of sales. Higher profit margins may indicate that a firm has greater control over expenses than that of its competitors. Fundamental investors might view such data as a compelling argument for further consideration in a company’s stock.
1.3) Return on Equity
Return on equity (ROE) is another piece of data commonly used in fundamental analysis. However, unlike other financial ratios used in fundamental analysis, return on equity does not use a company’s stock price as a key variable in its calculation. Nevertheless, despite the exclusion of price, many analysts consider ROE to be one of the most important financial measures. In the final analysis, return on equity measures how efficient a firm is in generating its earnings. Moreover, ROE provides analysts with information pertaining to a company’s leverage, revenue, profits, margins, and ultimately its ability to return value to shareholders. Fundamental analysts often perform side-by-side analysis of one firm’s ROE to another.
Price-to-Earnings (P/E) is the most popular ratio that fundamental analysts use that takes in to account a stock’s current market price. The Price-to-Earnings ratio takes the current market price divided by its earnings per share. The P/E ratio provides one the quickest ways to determine the relative value of a stock. In terms of valuation, a high P/E ratio suggests that a firm’s stock is priced relatively compared to its earnings. Conversely, a low P/E ratio indicates that the stock is priced relatively low compared to its earnings. Nevertheless, a firm’s Price-to-Earnings ratio is not considered the be all and end all to fundamental investing. For instance, a high P/E ration does not necessarily mean that a firm’s stock price is overvalued. Indeed, P/E ratios do not account for company’s rate of growth. As such, high growth fir’s often justify their high Price-to-Earnings ratio.
A price-to-book (P/B) ratio is used by fundamental investors to compare a stock’s market to that of its book value. The price-to-book ratio is calculated as a firm’s current stock price divided by its book value per share. In essence, the price-to-book value is the total market capitalization of the firm divided by shareholders equity. In the final analysis, the P/B ration provides fundamental investors with an accurate barometer of whether the current price is overvalued relative the residual value of the company if were to liquidate in bankruptcy.
1.6) Dividend Discount Models
The dividend discount model (DDM) posits one basic assumption, namely that a firm’s stock price is determined primarily on the basis of discounting any future cash flows derived from dividends (Wafi et al, 2015). As such, the dividend discount model suggests that the real, or intrinsic, value of a company’s stock price is determined by calculating the present value of all future dividends that will be accrued while holding the stock. While the dividend discount model uses a number of different assumptions, it is generally used by fundamental investors in order to determine the intrinsic value of a given stock price. Moreover, investors use the model to determine whether or not a stock price is undervalued or overvalued.
1.7) Discounted Cash Flow Models
The discounted cash flow (DCF) model is similar to the dividend discount model in that it attempts to determine the value of a stock based on a projection of its future cash lows. However, the DCF model calculates the present value of all future free cash flow projections in order to determine the value of a company’s stock.
2) Technical Analysis
While fundamental analysis uses various financial statements and accounting to determine the value of an investment, technical analysis is based almost purely on market data. In essense, technical analysts “believe that price and volume data provide indicators of future price movements, and that by meaning these data, information may be extracted on the fundamentals driving returns” (Blume et al, 1994, p. 153). As such, technical analysis is dominated by close inspection of stock charts in order to observe past price action as well as trends in the overall market and individual stocks. Listed in the following sections are just a few of the factors used by technical analysts to determine the future direction of a stock’s price.
2.1) Market Trend
Current market trend has considerable weight on the decision making of technical analysts. Indeed, as the old adage states, “the trend is your friend”. As such, technical analysts examine short-term, intermediate and long-term trends in stock price. On most occasions, technical investors will look to make investments that are consistent with the trend and their time horizon. Countertrend investments are labeled as a contrarian maneuver.
2.2) Support and Resistance
All stocks develop support and resistance levels that are closely watched by technical investors. Resistance is labeled as an area where a stock meets selling pressure. Conversely, support is an area where stocks where a stock finds buying pressure. Moreover, a move above resistance, or below support is labeled as a breakout by investors. When this occurs, further upward movement (break above resistance), or decline (break below resistance) is expected.
Oscillators such as the Stochastic, Moving Average Convergence Divergence (MACD) and Relative Strength Index (RSI) represent tools technical analysts use to determine whether stocks have reached overbought and oversold levels. Moreover, investors use oscillators for such purposes as discovering bullish and bearish divergences between stock price and oscillator itself. Oscillators should not be used as a stand alone tool for making trading decision, it could be part of a much bigger trading strategy.
This paper has demonstrated the primary differences between the fundamental and technical schools of investment analysis. Indeed, in stock investment and analysis, technical and fundamental analysis resides on two completely opposite sides of the spectrum. While neither type of analysis is necessarily right or wrong, the decision of whether to apply a technical or fundamental approach is entirely contingent on the investor themselves. In the final analysis, each investor will choose the approach that best suits their investment strategy and time horizon.
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