CommonLounge Archive

Fundamental Analysis, Technical Analysis and Value Investing

February 04, 2018

Fundamental Analysis

There are various techniques that are followed by investors to analyze stocks.

Fundamental analysis is a method to determine a stock price movement based on some underlying factors. The analysis could be performed on a holistic level for the industry or at an economic or global level. It helps in answering different questions, such as:

  • How well has the firm performed in terms of its revenue movement?
  • How competent is the firm in paying debt both in the short and long term?
  • How profitable is the firm using different metrics and what projections can be made regarding future movement of the stock using the current financial statements?

Fundamental analysis takes into account factors like

  • Business strength
  • The environment in which the company is currently operating
  • Market sentiments and global or macroeconomic events
  • Industry conditions that drive a stock or company performance as a whole.

All these parameters taken together are used to determine the inherent value of a firm. This analysis is carried out by investors who usually are looking at a stock for a long term investment — this is a sound way of making investment decisions and is dependent on the underlying assumptions and their effects on the stock price, and thus building future forecasts.

After an appropriate valuation exercise is conducted for a stock, a “Target Stock Price” is determined (we will discuss valuation in more detail below). The “Current Stock Price” (CP) is then measured against the Target Price (TP) — if the CP > TP then the company is likely over-valued and an investment will not reap profits in the future. On the contrary if the CP < TP, the stock has a lot of potential and is a good buy at current levels.

In the second scenario the proportion by which the Target Price is greater than Current Price matters a great deal for analysts and investors, since it helps ensure a margin of safety (a term generally used to provide some buffer to investors to account for anomalies in the financial model while conducting the valuation exercise).

Quantitative and Qualitative Techniques Followed by Investors

Stock analysis by Equity Research Analysts is an in-depth process often involving two stages — Quantitative and Qualitative Analysis.

  • Quantitative Analysis: The analysis quantifies a firm’s performance with factors such as revenue drivers, profitability and other financial ratios, performance based on future forecasts, and the effect of these parameters on the stock price. Valuation multiples like Price-to-earnings (P/E), Price-to-book value (P/B) etc are important values that determine stock movement. These will be covered in depth later in the guide.
  • Qualitative Analysis: Factors which cannot be quantified but play a major role in determining a company’s performance and in turn helping the company’s stock gain momentum are known as qualitative factors. From decisions of the management team to the brand image of the company — all these features help clarify certain answers which are difficult to determine purely based on financial calculations. A small company with great management can be expected to have good returns in terms of its stock movement since managerial decisions would help in shaping the company’s future — directly impacting the stock returns.

Analysts consider lot of factors when forming their expectations about a company’s future performance.

Technical Analysis

Technical Analysis is the process of determining stock or equity movement by interpreting statistical activity pertaining to a stock or the market as a whole. Technical analysis and fundamental analysis are complementary to one another and help investors make better decisions on both the long and the short terms. They are mutually exclusive.

Technical analysis involves relying on mathematical and statistical analysis like price change or the amount of buying and selling activity in terms of trade volume.

Let’s consider an example — say Apple (NASDAQ: AAPL) is currently trading at $174.79. As seen from the chart (Figure 1), below the price movement for last 1 month is witnessed, with current volume approaching a level of 11 million. The volume signals the number of shares being bought and sold in the market, which can be a great indicator to estimate the number of investors currently holding positions in the stock. The opening and closing price for the stock and what range the price was spread across a duration support analyst assumptions and foreseeable future trends.

Some of the key patterns that technical investors look for are Moving Averages (an indicator based on past stock prices and represent stock trends, they are of two types Simple and Exponential Moving Averages), price range, volume etc. Technical analysts believe that there is no point analyzing financial statements since most of the intricate details and relevant information could be tracked by stock price analysis from historical trends.

Figure 1: Price Chart for Apple as on 5th January 2018Market Watch

As seen from Figure 2, the volume as on 5th January 2018 has touched close to 1.3 Million at 9:30AM EST with a simple moving average (50-day period) of 172.98, stating that the stock price for the previously 50 days is recorded at this point. It is an established fact that a lag emerges if the number of days for which the moving average is calculated increases, hence a 200 day moving average will have a bigger lag in comparison with a 50 day moving average.

Figure 2: Price Chart for Moving Average as on 5th January 2018 (for the past 10 days)Market Watch

The Wisdom of Crowds

Another factor considered while analyzing a stock technicals is market sentiment or crowds psychology. Crowd behavior is tracked on various account in terms of exit and entry points and the logic behind these entries and exits. A lot of analysts follow a contrarian view point so when most of the investors are ready to enter a market maybe during a bullish stage, some investors book profits and exit and the same happen for an opposite scenario. Crowd study provides interesting insights into investors behavior and the herd mentality that is an integral of market sentiments and drive stock moments at various instances. While some analysts believe that following the trends could be lucrative to make short term profits, other follow a contrarian approach and go for an opposite view point.

The results of fundamental analysis and technical analysis may not be consistent all the time, which is due to the fact that each of them is more suitable for a specific time horizon. A fundamental analyst often looks for a long term stock while a technical analyst usually aims to make gains as he makes speculations on a shorter term basis (trying to take advantage of short term volatility), by measuring past trends in order to predict future movements in a stock (precisely for a shorter duration). Technical analysis may have its deficiencies, as a lot of investors believe that the probability of a stock repeating past trends is rare and depicts certain anomalies for long term investments.

Value Investing – Warren Buffet’s Approach

Benjamin Graham and David Dodd (professors at Columbia Business School and regarded by Warren Buffet as his gurus) are valuable contributors to the ideology of value investing. They are market veterans whose writings in the past and at present help investors in understanding how the concept of value investing differs from other investment school of thoughts.

Value Investors are individuals who look for stocks which are currently trading at a low price and has a potential to be muti-baggers (provide 5-10x times returns then their current price) because of strong fundamentals and sound financials. The art of spotting such companies before they emerge as top performers is known as value investing.

Though it is regarded as a tedious exercise since a lot is at stake, the process can reap hefty returns in the long run if done after enough preparation and analysis of available information. As explained above in Relative Valuation section, a low P/E multiple is often regarded as a good measure of analyzing a value stock, this coupled with certain moats that the company has become a criterion for searching a good stock. (A moat is a capability that the firm possess in terms of product or service niche which is difficult to replicate)

A stock is a reflection of a company’s performance. As an investor, if it is easier to make use of the available financial information, trends could be further analyzed to predict if the company’s future performance seems promotable or bleak. A firm’s managerial decisions help in determining its future. A business model which is easier to understand becomes a prime factor to make appropriate investment in a company.

If one is confident enough that the company will perform on similar grounds in the future and will persevere in times of crisis because of its fundamental strength, a stock can very well be regarded as a value stock. Value stocks are often regarded as stocks that beat market index and are out-performers. So if the index as culmination of 100 stocks has given 60% returns in 10 years, a value stock is expected to provide 62-65% (or even more) returns in the same time period.

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