Differences Between Fundamental and Technical Analysis
Fundamental analysis refers to the analysis of financial aspects of business like financial statements and financial ratios and other factors like economic and others affecting the business to analyze the fair market value of its share/security whereas technical analysis refers to the analysis of share/security fair price by examining and analyzing the past trends and changes in price of shares and by studying historical information of business.
Fundamental analysis is a methodology of stock valuation, which evaluates a stock based on its intrinsic value (fair value). On the other hand, technical analysis is a methodology of stock valuation, which evaluates a stock based on charts and trends and predicts the future price of the stock.
Both methods are used for evaluating the stock and prediction of future stock prices. Still, while fundamental analysis focuses on the intrinsic value of the stock, technical analysis focuses on the past trend of the price movement of stock.
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 critical path to follow.
What is Fundamental Analysis?
Fundamental analysis aims to find the enterprise value of the companyEnterprise Value Of The CompanyEnterprise Value is a measure of a company's total value that spans the entire market rather than just the equity value. It includes all debt and equity-based ownership claims. This value, which is calculated as the market value of debt + market value of equity - cash and cash equivalents, is particularly relevant when valuing a takeover.. It means arriving at its Intrinsic price. This kind of analysis uses Economic factorsEconomic FactorsEconomic factors are external, environmental factors that influence business performance, such as interest rates, inflation, unemployment, and economic growth, among others.. These factors prove 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
- In the long run, Stock Price corrects itself.
- You can make gains by purchasing an under-valued stock and then wait for the market to correctMarket To CorrectMarket Correction is usually referred to as a fall of 10% or more from its latest high. It happens due to various reasons such as declining macro-economic factors, intense pessimism across the economy, securities specific factors, over-inflation in the markets, and so on. 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 the characteristics of technical analysis are:
- This analysis uses past price movements to predict future price movements.
- Trends and Patterns play a significant 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.
Fundamental vs. Technical Analysis Infographics
Let’s see the top differences between Fundamental vs. Technical Analysis.
Steps 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 AnalysisRatio AnalysisRatio analysis is the quantitative interpretation of the company's financial performance. It provides valuable information about the organization's profitability, solvency, operational efficiency and liquidity positions as represented by the financial statements.. Carry out Horizontal and Vertical AnalysisVertical AnalysisVertical analysis is a kind of financial statement analysis wherein each item in the financial statement is shown in percentage of the base figure. The formula is: (Statement line item / Total base figure) X 100.
- Evaluate Trends over time. Compute the percentage increase or decrease relative to the base year.
- Understand where the company has applied its resources. Know the proportions in which they are distributed among various accounts (balance sheetBalance SheetA balance sheet is one of the financial statements of a company that presents the shareholders' equity, liabilities, and assets of the company at a specific point in time. It is based on the accounting equation that states that the sum of the total liabilities and the owner's capital equals the total assets of the company. and income statement).
- The next tool that you must adopt is Ratio Analysis. It will help you understand the changes in the company’s Financial Situation.
- Note that, Ratios are parameters and not absolute measurements. Hence it must be interpreted cautiously.
Step 3: Perform Financial Modeling
- Forecast the future Financial of the Company (financial modeling) for the next five to seven years.
- You may require a lot of information and assumptions here.
- The ultimate goal is to understand how the financial statementsFinancial StatementsFinancial statements are written reports prepared by a company's management to present the company's financial affairs over a given period (quarter, six monthly or yearly). These statements, which include the Balance Sheet, Income Statement, Cash Flows, and Shareholders Equity Statement, must be prepared in accordance with prescribed and standardized accounting standards to ensure uniformity in reporting at all levels. and the stock price will look in the future.
Step 4: Carry out Valuation Analysis
Many Valuation techniques are company/industry dependent. DCF and Relative Valuation approaches (like PE MultiplePE MultipleThe price to earnings (PE) ratio measures the relative value of the corporate stocks, i.e., whether it is undervalued or overvalued. It is calculated as the proportion of the current price per share to the earnings per share. Price to book value ratioPrice To Book Value RatioPrice to Book Value Ratio or P/B Ratio helps to identify stock opportunities in Financial companies, especially banks, and is used with other valuation tools like PE Ratio, PCF, EV/EBITDA. Price to Book Value Ratio = Price Per Share / Book Value Per Share , Price to Cash FlowPrice To Cash FlowPrice to Cash Flow Ratio is a value indicator that measures a company's stock price in relation to the cash flow amount it generates. This is determined as the ratio of Price Per Share to Operating Cash Flow Per Share. , etc.), SOTP valuationSOTP ValuationSum of the Parts Valuation is a valuation method wherein each of the subsidiary or segment of a Company is separately valued & then all of them are added together to estimate the business’s total value. is used in most cases. However, 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 procedures 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 your company of interest by comparing it to its peer group.
Some of the valuation parameters used in this are:
- PE ratioPE RatioThe price to earnings (PE) ratio measures the relative value of the corporate stocks, i.e., whether it is undervalued or overvalued. It is calculated as the proportion of the current price per share to the earnings per share.
- EV/EBITDAEV/EBITDAEV to EBITDA is the ratio between enterprise value and earnings before interest, taxes, depreciation, and amortization that helps the investor in the valuation of the company at a very subtle level by allowing the investor to compare a specific company to the peer company in the industry as a whole, or other comparative industries.
- EV/Sales etc.
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Steps to Carry Out Technical Analysis
Step 1: Identify which Securities interest you!
A little research on which sector is currently trending will help you decide what to buy or sell. It 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 essential.
Step 3: Select a Trading Account
You need the right share 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 a 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 at least spend a month testing your system with the end of day market data. Select a 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 is based on a long-term approach to evaluate the stock and suggests the analysis of data for several years. This type of approach helps the investors select those stocks for investment whose value is expected to increase in the future. Technical analysis is based on a short-term approach to evaluate the stocks, and it is for this reason that it is more relevant for day tradersDay TradersThe day trader is an individual who trades in the financial markets daily to earn profits by exploiting the inefficiencies present in the market. The three types of traders are - individual traders, financial institution traders, scalpers and momentum traders. as the purpose of the analysis is to select those stocks which can be purchased now to be sold at higher prices in a shorter period of time.
- Fundamental analysis takes into account the intrinsic value of a stock for identifying opportunities for long-term investment. The technical analysis evaluates the past price movements of a stock and predicts how a stock will perform in the future i.e., whether its price is expected to increase or decrease over a shorter period of time.
- The objective of fundamental analysis is investing since it is a long-term approach. However, technical analysis is concerned with trading objectives.
- Decisions are arrived at in fundamental analysis based on available data and financial statements. On the other hand, decisions are based on charts and price movement trends in technical analysis.
- Fundamental analysis considers both past and presents data about a stock, whereas technical analysis considers only past data.
- Fundamental analysis is useful for long term investors. In contrast, technical analysis is useful for day traders and short-term traders who wish to earn profits by selling the stock over a shorter period of time.
- No assumptions are involved in fundamental analysis. In technical analysis, many assumptions are to be taken, one being that price will continue to follow the past trend in the future.
- Fundamental analysis can help one decide whether a stock is overvalued or undervalued based on its intrinsic value. On the contrary, technical analysis helps one decide the correct time to purchase or sell a stock based on price movements.
Fundamental vs. Technical Analysis Comparative Table
|Criteria||Fundamental Analysis||Technical Analysis|
|Meaning||Analysis of stock based on the calculation of its intrinsic value||Analysis of stock and prediction of its price by the use of trends and charts about its price movement|
|Purpose||Evaluate the intrinsic value of stock and make a decision regarding investment||Analyze the correct time to enter or exit from the market with respect to a stock based on predicted future prices|
|Relevance||Long term investments||Short term investmentsShort Term InvestmentsShort term investments are those financial instruments which can be easily converted into cash in the next three to twelve months and are classified as current assets on the balance sheet. Most companies opt for such investments and park excess cash due to liquidity and solvency reasons.|
|Basis of decision||Historic and present data||Historic data|
|Source of data||Financial statements and the company’s present and past performance||Charts and trends|
|The factor for buying stock||When the stock price is less than the intrinsic value||When an investor believes that investor can be sold at a higher price in the future|
|Concepts used||Return on equity and return on assetsReturn On AssetsReturn on assets (ROA) is the ratio between net income, representing the amount of financial and operational income a company has, and total average assets. The arithmetic average of total assets a company holds analyses how much returns a company is producing on the total investment made.||Dow theory, price data|
|Approach followed||Long term||Short term|
|Assumptions||No assumptions are taken.||Many assumptions are taken, such as a similar price trend will follow|
Advantages & Disadvantages
#1 – Fundamental Analysis
- Use of Analytical methods: The methods and approaches used in Fundamental analysis are based on sound financial data. It eliminates the room for personal bias.
- 360 Degree Focus: Fundamental analysis also considers long term economic, demographic, technological, and consumer trends.
- A 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 help to gauge a better understanding of everything.
- Time-consuming: Carrying out Industry analysis, financial modelingFinancial ModelingFinancial modeling refers to the use of excel-based models to reflect a company's projected financial performance. Such models represent the financial situation by taking into account risks and future assumptions, which are critical for making significant decisions in the future, such as raising capital or valuing a business, and interpreting their impact., and valuation is not a cup of tea. It can get complicated and may need a lot of hard work to start with.
- Assumptions centric: Assumptions play a vital role in forecasting the financials. So it is crucial to consider the best and the worst-case scenario. Unexpected negative economic, political, or legislative changes may cause problems.
#2 – Technical Analysis
- Gives insights on volume trend: Demand & Supply governs the trading market. Thus it tells you a lot about Traders Sentiments. You can judge how the overall market is working. Usually, High demand pushes up the prices, and high supply pushes down the prices.
- Tells you when to enter and exit: Technical analysis is able to tell you when to enter or exit from the game.
- Provides current information: Price reflects all the available 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. It can prove risky in case of long time frames.
Fundamental vs. Technical Analysis Video
Both methodologies are being used the investors around the globe for market-related decisions. They are different from each other in the sense that while fundamental analysis is based on intrinsic value, technical analysis is based on historical price movements to predict the future prices of stock.
The fundamental analysis places its reliance on all those factors (known as fundaments), which are capable of influencing the price of a stock, such as economic, financial, and other relevant factors. It is based on the thought that though the prices don’t correspond to the effect of fundamentals in the short-term in the long run, the stock prices will adjust according to the fundamentals.
Technical analysis studies the historic price movement of the stock and is based on the stock market prices rather than the factors that may influence them. It doesn’t consider the value that stock holds; instead, it analyses the past trends and predicts future prices accordingly.
This article has been a guide to Fundamental Analysis vs. Technical Analysis. Here we discuss the top differences between this analysis along with the steps to perform the analysis. We also discuss there advantages and disadvantages. You may also have a look at the following articles –