Differences Between Fundamental Analysis and Technical Analysis
Ohhh, the Great War of the Ages! Fundamental Analysis vs Technical Analysis. Which one is better? Which one to go for? There can be different routes for different people.
Do you believe in reading charts and looking at trends? If yes, then you have a mindset based on Technical analysis. Or do you believe in making investment decisions based on Financials, Growth and EPS? Well, then you have a mindset based on fundamental analysis!
No doubt, that some may find both types of analysis useful for examining market action. It’s just that they both have a different School of thought. Your trading style and attitude will determine the kind of analysis beneficial for you. I have seen many investors combining both these analysis. While others concentrate only on one aspect and ignore the other.
Just to give you some examples:
Martin Schwartz, a successful wall street trader, gained reputation and wealth due to Technical Analysis. Whereas, Jim Rogers, a popular investor owes his success to fundamental analysis. Both of them may disagree on many concepts.But they will surely agree that emotional control is the most important path to follow.
So let’s discuss these two types of analysis to help you find out which suits you better: Fundamental Analysis vs Technical Analysis?
- Fundamental Analysis vs Technical Analysis Infographics
- What is Fundamental Analysis?
- What is Technical Analysis?
- How to carry out Fundamental Analysis?
- How to carry out Technical Analysis?
- Fundamental Analysis vs Technical Analysis Advantages & Disadvantages
- Snapshot of Fundamental Analysis vs Technical Analysis
Fundamental Analysis vs Technical Analysis Infographics
Below infographics on Fundamental Analysis vs Technical Analysis,throws light on major points of differences between the two analysis.
What is Fundamental Analysis?
Fundamental analysis aims to find the enterprise value of the company. This means arriving at its Intrinsic price. This kind of analysis uses Economic factors. These factors prove as the fundamental elements to determine the price. So if you are opting for the Fundamental route, be sure to perform the following analysis:
- Industry Analysis
- Company Analysis
- Economic Analysis
Major Assumptions of Fundamental Analysis:
- # 1 In the long run Stock Price corrects itself.
- # 2 You can make gains by purchasing an under-valued stock and then wait for the market to correct itself.
This investing technique is adopted by buy, hold and value investors.
What is Technical Analysis?
It is also a method of evaluating Securities. But the entire game here is dependent upon the statistics generated by the market. Charts and patterns are the Bread and Butter of technical analysis.
So let’s see what are the characteristics of technical analysis:
- This analysis uses past price movements to predict its future price movements.
- Trends and Patterns play a major role, rather than the Intrinsic Value.
- Market Price is everything. Factors affecting it are not considered, like in fundamental analysis.
The Three Golden Rules:
Technical Analysts adhere to these three Golden Rules:
- First Rule: Prices discount all information available to the public.
- Second Rule: Price movements are not random. Trends behind the price action can be established by using Technical tools.
- Third Rule: Price Trends are likely to repeat themselves.
do checkout the difference between Investing vs Trading
How to carry out Fundamental Analysis?
Step 1: Perform Industry Analysis
Dig and find out everything about the industry/sector in which the firm operates.
This type of analysis will give you insights about:
- Sector growth
- Contribution to GDP
- Trends in that sector
- Demand and Supply analysis
Step 2: Perform Company Analysis
- Understand the inside out operations of the Company using Ratio Analysis. Carry out Horizontal and Vertical Analysis.
- Evaluate Trends over time. Compute the percentage increase or decrease relative to base year.
- Understand where the company has applied its resources. Know the proportions in which they are distributed among various accounts (balance sheet and income statement).
- Next tool that you must adopt is Ratio Analysis. This will help you understand the changes in the company’s Financial Situation.
- Note that, Ratios are parameters and not absolute measurements. Hence must be interpreted cautiously.
Step 3: Perform Financial Modeling
- Forecast the future Financial of the Company (financial modeling) for next five to seven years.
- You may require lot of information and assumptions here.
- The ultimate goal is to understand how the Financial statements and stock price will look in the future.
Step 4: Carry out Valuation Analysis
Many Valuation techniques are company/industry dependent. Discounted Cash Flow and Relative Valuation approaches (like PE Multiple Price to book value ratio, P/CF etc), SOTP valuation are used in most cases. Although you may require other types of approaches based on company type.
Discounted Cash Flow Analysis:
In Discounted Cash flow analysis, you arrive at an Intrinsic price. The methods and procedure used for the same are interesting. We are not going to discuss the same in detail in this article. But let’s just jump to the step where you arrive at your intrinsic Share Price for the company. So here is how you will interpret your results.
- If Market Price > Intrinsic Share Price= Stock is Overvalued, Hence the Recommendation here is Sell the Stock.
- If Market Price < Intrinsic Share Price= Stock is Undervalued, Recommendation here will be Buy the Stock.
Relative Valuation Analysis:
This valuation technique makes use of comparable Company Analysis. Here you value you company of interest by comparing it to its peer Group.
Some of the Valuation parameters used in this are:
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How to carry out Technical Analysis?
Step 1: Identify which Securities interest you!
A small research on which sector is currently trending will help you decide what to buy or sell. This is the first and the major step that you will take.
Step 2: Identify the best suited Strategy.
Not all the stocks will fit into the same strategy. Identifying the best strategy for the selected stocks is important.
Step 3: Select a Trading Account
You need a right trading account with the required support, functionality and cost.
Step 4: Know your Tools & Interfaces
Select those tools that fit your trading requirements and strategies. There are lot of free tools available.As a novice trader you can try them first to know their features.
Step 5: Always Paper Trade first!
It’s a big world out there. To jump into the Trading Jungle without any prior knowledge is a big mistake. I would suggest you to atleast spend a month, testing your system with end of day market data. Select few stocks that meet your technical indicators requirements. See how they are doing each day.
Step 6: Set Stop Loss
Holding a losing Trade will dig a deeper hole for you. Set a Stop loss no matter what Stock you choose.
Fundamental Analysis vs Technical Analysis Advantages & Disadvantages:
- Use of Analytical methods: The methods and approaches used in Fundamental analysis are based on sound Financial data. This eliminates the room for personal bias.
- 360 Degree Focus: Fundamental analysis also considers long term economic, demographic, technologic and consumer trends.
- Systematic approach for deducing the Value: The statistical and analytical tools used,help in arriving at a proper Buy/Sell recommendation.
- Better Understanding: Rigorous accounting and financial analysis, helps to gauge better understanding of everything.
- Time consuming: Carrying out Industry analysis, financial modeling and valuation, is not a cup of tea. It can get complicated and may need lot of hard work to start with.
- Assumptions centric: Assumptions play a vital role in forecasting the financials. So it is important to consider the best and the worst case scenario. Unexpected negative economic, political or legislative changes, may cause problems.
- Gives insights on Volume Trend: Demand & Supply governs the trading market. Thusit tells you a lot about Traders Sentiments. You can actually judge how the overall market is working. Usually High demand push up the prices, and high supply push down the prices.
- Tells you when to Enter and Exit: Technical analysis is able to tell you when to enter or exitfrom the GAME.
- Provides Current Information: Price reflects all the known information about an asset. Prices may increase or decrease, but ultimately the current price is the balancing point for all information.
- Patterns give you direction: You can use patterns as a guide to direct your buy and sell decisions.
- Too many Indicators spoil the Charts: Too many indicators can produce confusing signals which may affect your analysis.
- Underlying Fundamentals ignored: Technical analysis does not take into account the underlying fundamentals of a company. This can prove risky in case of long time frames.
Snapshot of Fundamental Analysis vs Technical Analysis
|Definition||Stock value calculated using economic factors and company’s financial data.||Security price movements used to predict future price movements.|
|Time horizon||Long-term approach||Short-term approach|
|Data gathered from||Financial statements||Charts|
|Stock bought||When price falls below intrinsic value.||When trader believes they can sell it for a higher price.|
|Concepts used||Return on Equity (ROE) and Return on Assets (ROA)||Dow Theory, Price Data|
Try to ask some Investor: “Fundamental Analysis vs Technical Analysis”? Most of them will probably tell you that combination of both analysis is the best way to go. While most analysts on Wall Street focus on the fundamental side, major brokerage firms now employ technical analysis as well.
Whether you opt for Fundamental or technical analysis, always remember these two quotes of Warren Buffet. I truly believe they have got a very strong meaning.
Be fearful when others are greedy and be greedy when others are fearful.
The market is there to serve you and not to instruct you.”
So ask yourself these questions,
Do I focus more on technicals or fundamentals?
Should I try researching both of them?