There are two major kinds of investment analysis: fundamental and technical analysis. These two can be applied not only to stocks, but to a variety of other asset classes. Here, we introduce both. Later sections will go into more details.
This kind of investment analysis is popular among Wall Street analysts, although investors also look into fundamentals. It relies on studying financial reports disclosed by companies in the forms of quarterly and annual reports among others. The fundamental analysts look into trends in such factors as sales, costs, and profits. They also scrutinize corporate managements, events, product launches, and other announcements. Moreover, the analysts look into industry developments and overall economic growth.
The aim of this analysis is to determine the intrinsic value of a company and compare it to its current price. The intrinsic value is not only about the value today, but it is based on projections as to where the company is going. The value of a company is seen as the sum of all the future cash flows it’ll generate, discounted based on risk, to derive the present value.
There are various valuation techniques such as the Dividend Discount Models (DDMs), Free Cash Flow to Equity (FCFE) and Free Cash Flow to Firm (FCFF) models, and Residual Income (RI) models. These are known as absolute valuation models since they seek to derive company’s intrinsic value based on fundamentals.
In addition, there are relative valuation models. These models seek to compare company’s value in relation to other related companies (i.e. competitors in the same industry). Ratios such as Price-to-Earnings (P/E), Price-to-Sales (P/S), and Price-to-Book (P/B) are used among others.
Overall, fundamental analysis involves looking into past performance, and it seeks to project future performance based on it. Of course, a competent analyst will include ongoing developments that are likely to distort the trends. For example, company’s sales and profits have been growing for the past five years, but recent competition and/or technological developments are likely to cut into sales and profits. So, the forecast can’t just rely on the past but has to be adopted. Some other factors that need to be accounted for include increases in commodity prices (and resulting change in costs) and/or performance of the economy (i.e. recession). Political issues can also affect valuations.
Proper fundamental analysis is difficult to do. Many professional portfolio managers and wealthy investors rely on analyst reports produced at top investment banks and brokerage houses. The reports that retail investors get are usually less detailed and involve fewer efforts. Many are based on templates that are periodically updated with new data and information. Nevertheless, by learning as much as possible about fundamental analysis, and related financial statements, investors can get better understanding as to what they’re doing.
Fundamental analysis generally takes long-term perspective. It can tell whether the stock is worth buying or whether it should be sold (or current holdings reduced or added to). By comparing fundamentals of multiple companies, investors also get to narrow available choices.
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Many amateurs rely on technical analysis because it is seemingly easier than digging into financial statements as required by fundamental analysis. Professional traders also rely on it. When it comes to this kind of analysis, it is more suitable for short-term speculation. By trading in the short-term (for a day or several days), traders seek to derive higher profits but take more risks than with long-term investing, which is often done for multiple years.
Technical analysis looks at supply and demand to forecast where the price is going. It assumes that all the information is already included in the price and the market is right. (On the contrary, fundamental analysts say that the market can be at times irrational and misprices assets.) Price action, momentum, and volume tell a lot to technical analysts. They look into charts to determine trends- whether rising, falling, or flat. Trends can also be broken into long, medium, and short term. Since some technical analysts are looking at long-term trends, they will disagree that technical analysis is all about short-term predictions.
Some critics of this kind of analysis say it is a self-fulfilling prophesy. In a sense it is, but if something is likely to happen because others think it will, then why not take advantage of that opportunity?
Support and resistance lines, moving averages, and other technical indicators are the tools of the trade. Overall, technical analysis isn’t as easy as it looks. What’s more, if too many traders rely on the same indicators, it becomes much harder to make money.
Combining Fundamental and Technical Analysis
Some investors and traders seek to combine fundamental and technical analysis when performing research. This can actually work very well. Some traders do what is known as position trading, which isn’t exactly long-term investing but tends to rely on holding assets for longer periods of time (such as several months). This can also be considered as short to medium term investing. This type of a strategy can include seeking underpriced assets by looking at fundamentals, while looking at charts to see the potential of future rises. By looking at charts, good entry points can be made when it comes to price.
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These both kinds of investment analysis need to be performed well (either separately or combined), otherwise wrong conclusions will likely be reached. And wrong conclusions lead to losses. There is an alternative to not doing research, and many investors choose it. It relies on buying mutual funds and/or hiring a financial advisor. Still, some understanding of the markets and fundamentals is needed to avoid big investing mistakes.
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