There is more than one way to evaluate stock. Following the old adage, “Buy low, sell high,” isn’t as simple as it sounds. After all, the price of a stock selling at $50 per share could be either high or low, depending on whether that price is about to move up to $ 100 or spiral down to $20. But you can’t know for sure until it happens.
While no investor can predict the future with absolute certainty, careful analysis of present conditions may provide an indication of how individual stocks are likely to behave, at least in the near term. To assess those conditions, investors rely on two types of analysis: fundamental and technical.
Fundamental analysts evaluate a company’s financial strength and potential for increasing profits, while technical analysts anticipate investor demand for the stock by looking for patterns in price movement and trading volume. In practice, investors may use both types of analysis: fundamental to find companies worth buying (or selling) and technical to pinpoint the right time to make investment decisions.
Fundamental analysis for single stock
Most investors begin with fundamental analysis, since long-term changes in a company’s value derive ultimately from its business success. That success relies on a complex interplay of factors, internal and external. Internal factors include the quality of a company’s management, business strategies, and operating efficiency. At the same time, external factors include the trends or events affecting the entire industry — including the company’s competitors — and the economy in general.
As a starting point, fundamental analysts use information in a company’s financial balance sheet and income statement, which are filed annually in Form 10-K with the SEC and updated quarterly.
Focus on company’s earnings
Among the numbers that fundamental analysts focus on are revenue, or income, and earnings, or profits after expenses are paid. A pattern of steady increases in revenue and earnings often leads to a positive assessment. There are many ways to measure a company’s earnings, however, so it can be hard to draw meaningful conclusions from reported numbers.
That’s partly because despite the standards known as GAAP — for generally accepted accounting principles — companies have had leeway in how they report their earnings. Pro forma earnings, for example, indicate what a company’s results would have been if certain events had occurred earlier or hadn’t occurred at all.
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Another common measure, earnings before interest, taxes, depreciation, and amortization (EBITDA), was designed to discount certain accounting items to give a clearer picture of the earnings of companies with expensive assets to write down over time. With free cash flow, all cash expenses are subtracted from revenue, investments, and other sources of income to determine how much, if anything, is left over. Many analysts see free cash flow as a better measure of a company’s health and future worth than EBITDA since it identifies money that can be used to pay dividends, buy back stock, or be reinvested.
Free cash flow identifies the risk that may result from debt. Some analysts look at operating earnings per share (EPS) in an effort to exclude non-recurring or unusual items. But in part because operating EPS is not a GAAP-defined number, there is potential for subjectivity in determining what should be included. Some items that a company calls “special” or “non-comparable” might still be included in operating EPS if they’re considered relatively normal parts of doing business.
Charts reading and technical analysis
If you’ve ever looked at a chart showing the movement of a stock’s price over a period of time, you might have wondered how anyone could make sense of its complex patterns. But to a practiced technical analyst, the patterns can provide vital clues of what’s likely to happen to a stock’s price based on supply and demand.
Technical analysts look for meaningful patterns or trends that have heralded price increases or declines in the past and that may signal price movements to come. For example, an upsurge in volume may mean that big institutional investors are starting to trade in a particular stock. Or a particular shape in the pattern of price movements may signal classic market behavior, such as a downward correction before a rise.
Another aspect of technical analysis is a focus on duration, or how long a trend will last. It varies. But what doesn’t vary is the principle that if you’re making investment decisions based on a trend, you should stick with your approach until the trend ends.
Standard deviation measures the difference the actual closing price and the average closing price of a stock over a certain period of time. The larger the dispersion — or difference between the values — the higher the standard deviation and the more volatile the investment is considered to be. The smaller the standard deviation, the lower the dispersion and the volatility.
Technical analysts also focus on a stock’s volatility, sometimes expressed as its beta. Beta compares a stock’s volatility to the stock market as a whole — represented by the SP500 – which is set at 1. If the stock’s price moves more dramatically than the market — typically gaining more on a percentage basis when the market is going u and losing more when the market is going down, that stock has a beta higher than l, and is considered more volatile.
In contrast, if a stock’s price typically fluctuates less than the market, its beta is lower than l, and it’s less volatile. Volatility risk may play a large part in investment decisions. For example, you may have reasons to avoid a highly volatile stock even if a fundamental analyst gives it a strong buy recommendation. Conversely, you may have reasons to seek out highly volatile stocks in a rising market.
Volatility and risk
Investments with the highest potential return and therefore the greatest risk are often the most volatile. One effect of volatility is that if you sell a stock when the price drops — for whatever reason — you give up the opportunity to benefit should the price move back toward its average, or median, price or even higher. But if you keep the stock in your portfolio for an extended period, barring any unforeseen developments that could negatively affect its value, you may be in a position to benefit from volatility since at some point its price is likely to exceed its average price.
Volatility may be the result of systemic risk that affects an entire market or asset class or the risk may be nonsystemic, which means specific to the particular stock.
Fundamental vs Technical Analysis. Explained by Inna Rosputnia
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