Within every group of investment bankers and investors, the age-old debate never seems to end, which is better, technical analysis or fundamental analysis. Both financial analysis techniques have the same end goal, maximizing gains while investing in stocks. Hence, which technique is better? Which one should an investor go for? Or do both these techniques have their merits and are suitable for different people?
If you prefer undertaking your financial analysis by studying charts and investigating trends, you have the mindset for technical analysis. Or, if your investment decisions are guided by financials, revenue growth, profitability, EPS, etc., you have the mindset for fundamental analysis. In short, fundamental analysis utilizes a pragmatic, logical approach towards investing whereas technical analysis helps to understand the psychology of the market.
While both these financial analysis techniques are useful for studying market conditions and making investment decisions, some investors utilise technical analysis, whereas others might adopt fundamental analysis, depending upon their train of thought. Some investors even combine both techniques to experience the best of both worlds.
Towards determining, which analysis technique is better, we first need to understand what is technical and fundamental analysis.
What is Fundamental Analysis?
Fundamental analysis aims towards finding the value of a company. This implies the computation of the Intrinsic price of the company. It utilizes economic factors to determine the value of the business and its stock. Investors who opt for the route of fundamental analysis, analyze the following factors:
Revenue accounts to the sales earned by a company during a given period. Investors consider quarterly and annual sales of the business during their analysis. The vital component of revenue analysis is observing the direction of the revenues. While the increase in revenue is considered a positive sign, the decline of sales needs to be analyzed. Sales can decline due to a wide array of reasons which can include a one-off abnormality, loss of market share to competition, the decline in goods and services of the company etc.
Also in cases of quarterly increase or decline in sales, investors also need to consider whether the sales have increased or decline due to the performance of the company, change in demand due to seasonality etc.
EPS (Earnings Per Share)
While sales are important, converting those sales into profits is the basic goal of any business. In case a company has increased sales but is experiencing declining profitability or even losses, it is a matter of concern. It indicates expenditure exceeding revenues and poor management. Investors desire to invest in companies which have increasing margins and hence an EPS growth is an important indicator of a company’s financial performance.
In simple words, the P/E ratio or the price to earnings ratio of business is the prevailing stock price being divided by the annual EPS. There is no uniformity while determining a good P/E ratio. High growth companies trade at a higher P/E ratio whereas stable and low growth companies can trade at a lower P/E. Investors use P/E towards analyzing the growth prospects of a company and how much higher should one pay over the current earnings of the company to acquire its stock.
The financial performance of a company cannot be evaluated on a stand-alone basis. The company’s growth needs to be compared and evaluated against its industry peers. While a revenue growth of 10% might appear attractive, but not when the average industry revenue growth is at 18%.
The analysis of the prevailing macroeconomic conditions is vital while making an investment decision. Every industry has its own life and economic cycle with growth and decline. Hence it is essential to analyze whether the industry is in the start, middle or the end of a period of boom or recession.
What is Technical Analysis?
Technical analysis is a methodology utilized towards evaluating stocks and securities using market generated statistics. Charts and patterns are the most vital component of the technical analysis. Some of the charts and trends utilized in the technical analysis include:
This involves tracking the movement of stock prices to analyze whether a stock price is increasing or decreasing, and how long has this trend been going on. This helps investors in making investment decisions such as buying shares during a temporary downtrend, investing in stocks with increasing prices, etc.
While charts and trend may act as an ink blot test of a market, the volume acts as its lie detector. Trading volumes can indicate the strength of a trend and the possibility of its reversal.
Moving average lines can help in determining the overall direction of a trend. A moving average line merely plots the average stock price over a particular period. For instance, a 30-day moving average is an indication of the average stock price over 30-days. Investors prefer to buy when there is an upward trend in the moving average, and there is a small decline to offer the investor an entry point to purchase the stock at a lower price.
A wide array of technical indicators are found on top or bottom of a chart — these indicators aid in determining whether a stock has been oversold or overbought along with the strength of the movement. Relative Strength Index and Moving Average Convergence-Divergence are some of the indicators used by an analyst.
Throughout the 20th Century, the fundamental analysis was considered the most credible method of making investment decisions. But, in the 21st Century, high-speed computers, analysis tools, etc. have made it easy to conduct technical analysis and are widely available. Many investors and firms utilize computer modeling, black box trading, etc. to determine their points of entry and exit.
But investment decisions are being made based on technical and well as fundamental factors. Hence, rather than debating which technique is better, it is best to utilize both techniques and experience the best of both worlds. Investors can select stocks and sectors with strong fundamentals and utilize technical analysis towards making their investment decisions.