Fundamental vs Technical Analysis. Explained

While predicting the future with absolute certainty is impossible, investors can gain insights into how stocks might perform by analyzing current conditions. This involves two main types of analysis: fundamental and technical.

• Fundamental Analysis: This method assesses a company’s financial health and profit potential by examining its financial statements, management, and market position. The goal is to determine whether the company is a good investment based on its intrinsic value.
• Technical Analysis: This approach focuses on studying price movements and trading volume to identify patterns and trends. Technical analysts aim to forecast future stock movements based on historical data and market behavior.

In practice, many investors use both types of analysis: fundamental analysis to identify promising companies and technical analysis to time their investment decisions effectively.

Fundamental analysis for single stock

Most investors start with fundamental analysis because the long-term value of a company is fundamentally linked to its business performance. This performance is influenced by a mix of internal and external factors:

• Internal Factors: These include the quality of the company’s management, the effectiveness of its business strategies, and its operational efficiency.
• External Factors: These encompass industry trends, competitive dynamics, and broader economic conditions that impact the company and its sector.

Fundamental analysts typically begin by reviewing a company’s financial balance sheet and income statement, which are detailed in Form 10-K filed annually with the SEC and updated quarterly. This information provides a comprehensive view of the company’s financial health and performance.

Focus on company’s earnings

Fundamental analysts pay close attention to key metrics such as revenue (income) and earnings (profits after expenses). A consistent upward trend in both revenue and earnings typically signals a positive outlook for a company. However, interpreting these numbers can be challenging due to variations in how companies report their earnings.

Despite the use of Generally Accepted Accounting Principles (GAAP), companies often have some flexibility in their financial reporting. For instance, pro forma earnings reflect how a company’s results would have appeared if certain hypothetical scenarios had played out differently or if specific events had not occurred. This can make it difficult to draw straightforward conclusions from the reported figures.

Another important metric is earnings before interest, taxes, depreciation, and amortization (EBITDA). This measure is intended to provide a clearer view of a company’s earnings by excluding certain accounting factors, such as depreciation and amortization, which can be significant for companies with substantial assets.

Free cash flow, on the other hand, subtracts all cash expenses, investments, and other income sources from revenue to determine the remaining amount available. Many analysts consider free cash flow a better indicator of a company’s health and future potential than EBITDA because it reflects the cash available for dividends, stock buybacks, or reinvestment.

Free cash flow also highlights potential risks related to debt. Some analysts focus on operating earnings per share (EPS) to exclude non-recurring or unusual items. However, because operating EPS is not defined by GAAP, its calculation can be subjective. Items deemed “special” or “non-comparable” by a company might still be included in operating EPS if they are considered regular business activities.

Charts reading and technical analysis

If you’ve ever examined a stock price chart and found its patterns perplexing, you’re not alone. However, for an experienced technical analyst, these patterns offer crucial insights into future price movements, driven by supply and demand dynamics.

Technical analysts seek out significant patterns or trends that have historically preceded price changes. For instance, a surge in trading volume might indicate that major institutional investors are beginning to buy or sell a stock. Similarly, certain price movement shapes might suggest well-known market behaviors, such as a temporary drop before a subsequent rise.

A key component of technical analysis is assessing the duration of trends—how long they are likely to persist. While the length of a trend can vary, the core principle remains: if you’re basing investment decisions on a trend, it’s important to adhere to that strategy until the trend shifts.

Beta explained

Technical analysts also evaluate a stock’s volatility, often using its beta. Beta measures a stock’s volatility relative to the overall market, typically represented by the S&P 500, which is assigned a beta of 1. A stock with a beta greater than 1 is more volatile than the market, meaning it tends to experience larger price swings — gaining more when the market rises and losing more when it falls. Conversely, a stock with a beta less than 1 is less volatile, showing smaller fluctuations compared to the market.

Volatility can significantly impact investment decisions. For instance, you might avoid a highly volatile stock even if it receives a strong buy recommendation from fundamental analysts. On the other hand, in a rising market, you might actively seek out such volatile stocks to capitalize on their potential for higher returns.

Volatility and risk

Investments with the highest potential returns, and therefore the greatest risk, are often the most volatile. Volatility means that if you sell a stock during a price drop, you might miss out on potential gains if the price rebounds. Conversely, holding onto the stock over a longer period, assuming no major negative developments, could allow you to benefit from eventual price increases that surpass the stock’s average.

Volatility can stem from systemic risk, which affects the entire market or asset class, or from nonsystemic risk, which is specific to the individual stock.

Fundamental vs Technical Analysis. Explained by Inna Rosputnia

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