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There are broadly two schools of thought when it comes to determining the price of a company. One predicts the stock price based on research, whereas the other relies on historical stock prices to forecast the future stock price. The former is fundamental analysis, whereas the latter is technical analysis. Both methods have distinct qualities and appeal to different types of market participants. This article explains in detail the meaning of fundamental and technical analysis and how they are different from each other.
What is Fundamental Analysis?
Fundamental analysis is a method used to determine the fair or intrinsic value of a company. It relies on the company’s fundamentals, such as revenue growth, profit growth, accounting ratios, management’s competency and business model to determine the value of its share. Apart from this, the analysis also takes into account the state of the economy and the strength of the industry to determine a company’s fair value.
Once the intrinsic value of the company is determined, the analysts either mark it as overvalued or undervalued. An undervalued company’s share price is less than its intrinsic value, and an overvalued company’s share price is higher than its intrinsic value. The primary assumption behind this is that in the long term, the share price of a company will be similar to its intrinsic value. So, the price of an undervalued share will grow to reach its intrinsic value, and the price of an overvalued share will drop until it reaches its intrinsic value.
Long-term investors use fundamental analysis to identify undervalued and overvalued shares so they can make buy or sell decisions on the stocks. An undervalued share makes an excellent buy, whereas an overvalued share indicates a ‘sell’.
Types of Fundamental Analysis
There are two types of fundamental analysis that you can do to arrive at the intrinsic value; they are quantitative and qualitative.
Quantitative analysis can be done using the numbers such as revenue, expenses, profit, assets, and liabilities. On the other hand, qualitative analysis is done by studying the business model of the company, its business cycles, customer base, management competency, intangible assets, and corporate governance.
Quantitative analysis
Financial statements are the biggest source for conducting quantitative analysis. Income statements, balance sheets, and cash flow statements are used to determine the financial health of a business. Following are some of the quantitative parameters to look at while doing fundamental analysis.
- Revenue growth: It is the primary indicator of how the business is performing. If the revenue is consistently improving, then it indicates the company is expanding its operations and attracting new customers.
- Profit growth: The ultimate goal for any business is to earn profits. A consistent increase in the profit and the margins indicates the company’s health is improving or stable. On the other hand, declining profits indicate falling efficiency of the business.
- Return ratios: Some of the important return ratios you must look at are return on equity, return on capital employed, and return on assets. These indicate how well a business is using its assets and capital to earn profits. A high and growing number indicates that the business is using its assets and capital efficiently. On the other hand, a falling number indicates otherwise.
- Working capital ratios: Current ratio and quick ratio are two working capital ratios that indicate the liquidity of the company. Ideally, a current ratio of 2:1 and a quick ratio of 1:1 indicate that the business is using its cash and cash equivalents correctly and has enough liquidity. However, anything less indicates that the business doesn’t have enough current assets to repay its current liabilities. Moreover, anything more than the ideal ratio indicates that the company is not using its working capital efficiently.
- Debt to equity ratio: A company can use debt to expand its business. However, a growing debt on the books can be a red flag. Ideally, a debt-to-equity ratio of 1x or below is considered ideal. Anything more indicates the company is overleveraged and has higher outside obligations, which affects the profitability of the company.
These are just some of the many ratios used for quantitative analysis. You can use more parameters to understand the business better.
Qualitative analysis
The following qualitative parameters can help evaluate the business. Information regarding these can be easily found in the annual reports, quarterly presentations, and analyst calls.
- Business model: The business model explains how exactly the company is earning revenue and making profits. It is manufacturing goods and selling them, directly trading in them, or the company offering a service. By understanding the business model, you can judge whether the company is updating itself constantly with changing times or using a century-old model in the current modern-day world.
- Competitive advantage: A company can survive in the long term only if it has something unique to offer than its competitors. This is known as a competitive advantage. For example, for Amazon, the competitive advantage is its customer service and its ability to offer better prices than its competitors. If Amazon loses its competitive advantage, the chances of it surviving will be difficult.
- Management: Management plays a vital role in the success of a business. Take Tata, for example. Under the leadership of JRD Tata and Ratan Tata, the company grew multifold. It’s because of their leadership that the investors trust the Tatas.
- Corporate Governance: It defines the policies, values, and ethics of a business. Investing in a business that is ethically right and follows certain policies and values would be more fruitful than investing in a business with no formal code of conduct. You can read a company’s policies and values in its annual report. You can check whether the company is following these policies before investing in it.
By using the above quantitative and qualitative parameters, you can arrive at the intrinsic value of a company and decide whether it’s undervalued or overvalued and make an investing decision.
What is Technical Analysis?
Technical analysis is another school of thought that analyses a stock based on its historical price. It uses statistical analysis to evaluate a company based on its stock price, trading volume, and returns. Through this analysis, technical analysts forecast the future price and movement of the stock. The major assumption behind technical analysis is that all the fundamentals are already factored into the stock price, and they remain unchanged.
In technical analysis, the analysts believe that the past trading activity and movement of a share price can be valuable indicators to determine a share’s future price. Short-term traders use technical analysis to determine the movement of a company’s stock to make profits. Technical analysis can be used on shares, futures, options, bonds, currencies, commodities or any other security that are subject to market supply and demand.
There are several technical analysis indicators, such as price trends, chart patterns, and moving averages, that determine the direction of the security, the strength of the trend, and the likelihood of its continuation. All these indicators follow certain assumptions.
The first assumption is that the market discounts everything. This means all the fundamentals, market psychology, and other factors are already included in the stock price. The only thing that needs to be included is the market demand and supply for security.
Second, the price of a security moves in trends. The price of a security will follow a trend rather than move erratically. Be it an uptrend or down trend, it is expected to continue for a period of time before it reverses.
Last, history repeats itself. The repetitive nature of the price movements is mainly because of fear or excitement among the market participants. Hence it is easy to predict a trend by analyzing these emotions and chart patterns.
Indicators of Technical Analysis
There are two basic types of technical indicators, namely overlays and oscillators. As the name suggests, oscillators are indicators that move between minimum and maximum price and focus on market momentum, and determine the trend or its reversal. Overlays, on the other hand, are used to identify overbought and oversold stocks.
Oscillators
- Moving Average Convergence Divergence (MACD): MACD is a widely used technical indicator. It uses two moving averages to determine the trends and momentum of a stock. It compares the short-term and long-term momentum to predict the future direction. Typically, a 12-day and 26-day moving average of a stock is used. If the short-term average cuts the long-term average from below, the stock will trade higher. If the short-term average cuts the long-term average from above, it indicates a sell-off.
- Relative Strength Index (RSI): It measures the speed and change of price movements. RSI oscillates between 0 to 100 and is considered overbought when it’s above 70 and oversold when it’s below 30. So, if a stock has an RSI of 70, it means it is overbought, and its price will fall in the future. On the other hand, if it is oversold, the price will increase in the future.
Overlays
- Support and Resistance: Support and resistance are price points on a stock’s chart that indicate maximum buying and selling price points. The resistance point is the maximum price the traders expect the stock to go in a given period of time. The resistance is always above the current market price and indicates a point where the maximum supply happens. Support, on the other hand, is the minimum price the traders expect the stock to fall to in a given period of time. There are very few chances that the stock will fall below the support level, which indicates the price at which there is maximum demand. It is always below the current market price, and it is a point where the share price bounces back to the current levels.
- Trendline: When different prices of a share are marked on a chart and connected with a line, the resulting line is called a trendline. It is drawn on highs or lows to indicate the direction of a stock. Trendline depicts the support and resistance levels over a period of time. An upward-sloping trendline depicts an uptrend, whereas a downward-sloping trendline depicts a downtrend.
- Bollinger bands: A technical analysis tool that is defined by a set of trendlines is known as Bollinger bands. A Bollinger band comprises three lines, namely a simple moving average, an upper band and a lower band which is plotted two standard deviations away from the simple moving average. Bollinger bands are used to identify overbought and oversold situations. When the price touches the upper band, it can indicate an overbought situation, and when it touches the lower band, it can indicate an oversold situation.
Apart from these, there are several other technical indicators that traders use to predict the direction of a share price and the trend, which will help traders make a profit.
Why Fundamental Analysis And Technical Analysis is Required?
Both fundamental and technical analysis is important when investing and trading in the stock markets. In the case of long-term investing, the fundamental analysis makes more sense as it uses multiple quantitative and qualitative parameters to determine the future price of a stock. Through fundamental analysis, you can understand the company’s financial health, its business model, and the management’s competency.
With technical analysis, you can understand the short-term price movements and determine the entry and exit points for a stock. It also helps analyze the market trends, understand investor psychology, and also detect early signs of a trend reversal. All this can be done just by studying the price movements of a stock.
Which analysis to use – fundamental or technical analysis?
Both fundamental and technical analysis are important when investing in the stock market. However, they are used for different purposes. Fundamental analysis is used for long-term investing, whereas technical analysis is used for short-term investing.
Long-term investing requires more in-depth research about the company and how the micro and macroeconomic factors affect the business and a company’s intrinsic value. Hence fundamental analysis is a better choice when you choose to invest in the markets for the long term (a period of at least one year).
Short-term investing is done solely based on price movements and short-term trends. Technical analysis helps in analyzing the trend and finding the best entry and exit points. Hence for a period of less than one year, technical analysis is the best fit.
Difference Between Fundamental Analysis And Technical Analysis
| Parameter | Fundamental Analysis | Technical Analysis |
| Meaning | It analyses securities based on their intrinsic value. | It determines the future price of a security based on historical prices. |
| Purpose | To identify undervalued stocks for long-term investing. | To identify the right entry and exit point from the market to earn profits. |
| Horizon | Long-term (above one year) | Short-term (below one year) |
| Data | Used both past and present data to determine the intrinsic value | Uses only past data to predict future price |
| Relevant for | Long term investors | Short term traders |
| Indicators | Quantitative and qualitative indicators such as revenue, profits, business model, and competitive advantage | Price charts, trends, patterns, moving average, RSI, and MACD |
| Methodology | Examines the economic impact on the industry, and company, along with analyzing the financials of the company. | Examines historical prices and current market psychology and their impact on the future price of a security. |
| Analysis | It is purely based on the quantitative and qualitative data available. | It is very subjective and is based on the assumptions of the trader. |
| Macro and micro economic factors | Are considered when determining the intrinsic value | Are not considered when predicting the future price |
Frequently Asked Questions
Which comes first, fundamental analysis or technical analysis?
Technical analysis is for short-term trading, whereas fundamental analysis is for long-term investing. You must decide whether you want to invest for the long term or trade in the short term and choose one type of analysis.
Why is fundamental analysis better?
Fundamental analysis is based on the company’s past performance and its financial health. When determining the intrinsic value, all parameters, including the company’s financials, industry prospects, and economic conditions, are factored in. Since it takes into consideration the entire picture during the analysis, fundamental analysis is usually considered better.
Is technical analysis enough for trading?
Although the technical analysis doesn’t guarantee profits, it is a thorough study of all indicators. Traders have used it for several decades in the past to trade in the stock market.
What are the 4 basic principles of technical analysis?
Technical analysis is based on four principles. First, markets alternate between expansion and contraction. Second, a market trend will continue for a long period of time until it reverses. Third, a trend ends in a climax or rollover. This means a trend ends when the last of the buyers buy shares, and there is no more left to buy. Or it ends when the buying or selling loses steam. Last, momentum precedes price. This means that when the market makes a sharp move, the price is likely to continue in the same direction.
What are the different types of fundamental analysis?
There are two types of fundamental analysis you need to do to find the intrinsic value of a stock. First is quantitative analysis, and send is qualitative analysis. Quantitative analysis is a study of the financial statements of a company. Qualitative analysis, on the other hand, involves analyzing the business model, management’s competency, or the company’s competitive advantage.
What is an efficient market hypothesis?
The Efficient Market Hypothesis (EMH) states that the share price reflects all the information, and generating consistent returns is impossible. In other words, the stock trades at fair value on the exchange, which makes it impossible for investors to buy undervalued shares or sell them at inflated prices. Hence it becomes impossible to generate above-market returns, and the only way to generate excess returns is through investing in risky investments.
