If you are interested in investing, one of the most important toolsets you have is the ability to decide when to buy and sell stocks and other investments. In order to decide when to buy and sell, you need to analyze your investments. Two of the most popular ways to analyze are fundamental analysis and technical analysis.
- Fundamental Analysis focuses on an investment's underlying financial potential.
- Technical Analysis focuses on recent market trends and the performance of stocks.
- Both have staunch advocates, and it's important to understand how they work.
- Each method tells you different things when you're deciding whether the moment is right to buy or sell an investment.
What Is Fundamental Analysis?
Fundamental analysis analyzes stocks by focusing on the company's fundamentals. That means looking at the business' earnings, debt, and other performance metrics to determine the overall value of the company and the value of each share of stock.
Fundamental analysis often employs ratios to compare different stocks. This helps you infer the company's underlying value. For example, if a company earns $20 per share, you might assume that the stock price should be twice that of a similar company earning $10 per share. But this simple example scratches only the surface of what you can do with fundamental analysis.
When analyzing a company's fundamentals, an investor might have to make some assumptions. For example, you could assume a company's revenue, profitability or even the dividend growth rate to estimate the value of a share of stock. Investors use formulas like the capital asset pricing model (CAPM), discounted cash flow (DCF) analysis, ratio comparisons, and many other formulas and models to make their own predictions.
One major proponent of fundamental analysis is investor Warren Buffett. Buffett uses fundamental analysis as part of picking value stocks in his portfolio. Benjamin Graham, Buffett's college professor, was another big proponent of value investing methods that focus on a company's fundamentals.
If you believe a company's financial performance is the major driver of the company's value, you should focus primarily on fundamental analysis when picking investments.
Popular Tools for Fundamental Analysis
- P/E Ratio: price-to-earnings ratio, often called the P/E ratio, compares stock prices based on the company's earnings. As the name implies, this ratio divides the stock price by the company's earnings per share. Compare this ratio with other stocks in similar industries to get an idea of where a company's stock price should be in relation to its peers.
- Earnings per Share: Earnings per share is a simple calculation that tells you how much a company is earning per share outstanding. Simply divide the company's earnings by the number of shares outstanding. But most financial websites provide this number without you having to do the math.
- PEG Ratio: The PEG ratio shows the P/E ratio with respect to a company's growth rate. Companies that are growing fast are likely to be worth more in the future than ones that grow more slowly. And the PEG ratio takes that growth rate into account.
- Book Value: Book value, or book value per share, is a conservative measure of a company's value. Book value looks at what a company would be worth if it were liquidated today. If a stock price is lower than the book value per share, there's a good chance the stock is undervalued.
- Return on Equity: Return on equity (ROE) is a percentage calculated by dividing a company's net income by its shareholders' equity. And the shareholders' equity is simply the company's total assets minus its liabilities.
Fundamental Analysis Pros and Cons
- Based on company financial performance
- Ideal for longer-term investments
- Uses common metrics built into most popular brokerage platforms
- Asset values are typically based on past financial results
- Target stock prices are often determined based on a company's peers and on assumptions that can make results subjective
- Many numbers are updated only quarterly
What Is Technical Analysis?
Technical analysis focuses on trends in an asset price, such as a company's stock price. Rather than focusing on earnings, technical analysts look at recent swings in an asset price to chart out what they believe is the most likely future price.
Technical analysis uses charts and statistical analysis models to estimate asset prices in a quickly changing marketplace. And technical analysis is also used in the high-speed world of options and forex trading, among other markets, not just stocks.
A big part of technical analysis involves looking at the typical behavior of a specific investment. A basic technical analysis might look at a stock just to see if the price is above or below the stock's recent pricing trend. If it is below, it could be a sign that the stock price is about to go up. But if the price is above the trend, it could be overpriced and set for a drop.The nature of technical analysis of stocks makes it more valuable for shorter-term traders who are looking to turn a quick profit.
Popular Tools for Technical Analysis
- Trendlines and Patterns: The most important skills for technical analysis include the ability to read and understand charts. Traders using technical analysis use trendlines, continuation patterns, and reversal patterns to predict future price movements. An example here is Bollinger Bands. These follow recent moving averages plus and minus two standard deviations. (See chart above for an example.)
- Relative Strength Index: Relative strength index (RSI) measures the speed of price changes of an asset and helps to determine whether it may be overvalued or undervalued.
- Volume Indicators: Several different measurements track buying and selling volumes over a period of time. The Chaikin Money Flow Oscillator is an example of a commonly used volume indicator.
Technical Analysis Pros and Cons
- Based on recent market trends
- All traders have access to similar information
- Advanced charting tools help plot trade decisions
- Doesn't take into account financial results
- Computer algorithmic traders can make faster decisions than human traders
- Some strategies can be extremely complex and intimidating for newer traders
What Are the Differences Between the Two?
Fundamental and technical analyses of stocks are very different. Each one has its own proponents. But wise investors understand both and can use either when evaluating an investment.
Fundamental analysis focuses on long-term financial trends and how a company is performing compared to its market peers. If a company is making a lot of money, fundamental analysis says its price should probably go up. But if a company is losing money, the price should go down. There are many more technical aspects going on behind the scenes than this. But the crux of fundamental analysis is getting to a target stock price based on the company's financial results.
The big downside here is that you're almost always looking backward when it comes to hard data. Any forward-looking indicators are estimates from the company or your own analysis. But if you do a good job at that analysis, you could pick a winning long-term investment.
Technical analysis, on the other hand, looks primarily at very recent trends to earn a shorter-term profit. If traders are moving the stock in a certain direction, you may be able to learn something from that to earn a profit.
Technical traders are not generally as worried about what a company is going to be earning in five or ten years. They care most about what a stock is going to do over the coming days and weeks.
Which Is Better for You?
Deciding which is better for you depends on your investment style and goals. You might even use a hybrid of the two when making portfolio decisions.
- Fundamental analysis is best for investors who want to focus on the company's performance and who have a longer-term focus on their investments. Fundamental analysis is ideal for retirement and other longer-term investment accounts where a business's results over time will shape the investment price.
- Technical analysis is best for investors who want to capitalize on the movements of asset prices. This tends to be most useful for shorter-term investors and investors who are interested in riskier assets and trading strategies.
Further Reading: What is Investment Portfolio Analysis?
Other Ways to Analyze Stocks
Expert analysts use large spreadsheets that weigh out factors around revenue, expenses, profitability trends, sales trends, and comparisons with industry competitors to come up with target stock prices. They often rely on a mix of technical and fundamental indicators.
In addition to these tools, investors might look at a particular industry or business model and like it as a long-term investment opportunity. They may also be interested in behavioral investing. This investment strategy focuses on the companies they are most familiar with themselves.
Be sure the analysis method you use is a good one, whichever you choose since a bad method can lead to investing in low-quality companies. When in doubt, sticking with the fundamentals and technicals offers a tried-and-true strategy to manage your investments.
Make Sure You Understand the Difference
Fundamental and technical analyses are two of the most popular camps when figuring out how to analyze stocks and make investment decisions. Fundamental analysis is a longer-term analysis method. It focuses on a company's financial performance, sometimes compared to industry peers. And technical analysis of stocks is a shorter-term analysis method. It focuses on market price fluctuations and trends.
Either one could be right for you depending on your investment goals. Just make sure you always understand the tools and methods you are using so you don't make any expensive mistakes in the markets.