Fundamental Analysis and Technical Analysis

Every day, investors buy and sell shares of thousands of companies in the stock market. Some investors study a company's revenue and profits before buying its stock. Others examine how its stock price has been moving before making a decision. Even when they invest in the same company, their methods of evaluating the investment can be very different. So how do investors decide which stocks to buy and sell? Two of the most widely used approaches are fundamental analysis and technical analysis. Fundamental analysis is a method of evaluating a stock by examining a company's financial performance, financial condition, growth potential, and other factors that may affect its value. Technical analysis, on the other hand, examines historical stock prices, trading volume, and other market data to anticipate future price movements. Let's begin with fundamental analysis. Imagine that you are considering buying a small neighborhood bakery. What would you need to know to determine whether the asking price is reasonable? First, you would probably want to know how much money the bakery makes. How much bread does it sell? How much does it spend on ingredients and employees? After paying all its expenses, how much profit does it have left? The bakery's debt and cash reserves would also matter. Even if the bakery generates substantial revenue, it could be risky to purchase if it owes too much money. On the other hand, a bakery with sufficient cash might be better prepared to survive difficult economic conditions. You would also need to consider its future growth potential. If a new apartment complex were built nearby, the bakery might attract more customers. However, if a popular bakery chain opened right next door, its sales might decline. Examining a business's profitability, financial condition, and future prospects in this way is the basic idea behind fundamental analysis. The same principles apply to stock investing. Investors examine a company's revenue, operating income, net income, assets, liabilities, and cash flow. They may also study the outlook for its industry, the strength of its competitors, and the abilities of its management team. One important lesson is that a good company is not necessarily a good investment at every price. Imagine a company that consistently earns large profits and grows rapidly. If nearly everyone believes that the company has a promising future, many investors may want to buy its stock. As demand increases, its share price could become extremely high. Even an excellent company can be a disappointing investment if its shares are purchased at a price far above their underlying value. Conversely, a company experiencing temporary difficulties might become an attractive investment if its stock is inexpensive enough and its business eventually recovers. This is why fundamental analysis involves more than identifying successful companies. Investors must also consider whether the current stock price is reasonable compared with the company's estimated value. One commonly used measure is the price-to-earnings ratio, or P/E ratio. The P/E ratio is calculated by dividing a company's stock price by its earnings per share. For example, if a stock trades at $20 and the company earned $1 per share over the past year, its P/E ratio would be 20. This means investors are paying $20 for every $1 of annual earnings per share. Generally, when other factors are equal, a lower P/E ratio suggests that a stock is less expensive relative to its earnings. However, a low P/E ratio does not automatically make a stock a good investment. If a company's profits are expected to decline significantly, there may be a good reason for its low valuation. Conversely, a rapidly growing company may have a high P/E ratio because investors expect its future earnings to increase substantially. Ultimately, fundamental analysis involves combining different pieces of information to estimate the value of a business. However, because no one can predict a company's future with complete accuracy, any estimate of its value remains uncertain. How, then, does technical analysis work? Investors who use technical analysis pay particular attention to stock price movements rather than focusing primarily on financial statements. Because countless investors buy and sell shares based on their own expectations, stock prices constantly change. A stock chart displays these price movements over time. The simplest charts connect a series of prices with a line. However, candlestick charts, which display a stock's opening, highest, lowest, and closing prices over a particular period, are also widely used. The opening price is the first price at which a stock trades during a trading session, while the closing price is the final trading price of that session. The high and low represent the highest and lowest prices at which the stock traded during the period. By examining these charts, investors attempt to identify the direction and speed of price movements. For example, if a stock's price has been rising consistently for several months, investors may describe it as being in an uptrend. If its price has been falling consistently, it may be described as being in a downtrend. Technical analysts study these trends to evaluate whether they might continue. One commonly used tool is the moving average. A moving average is a line that represents the average stock price over a specified period. For example, a 20-day moving average is calculated using prices from the most recent 20 trading days. As each new trading day passes, the period used in the calculation moves forward. Moving averages can make it easier to recognize the general direction of a stock's price by smoothing out some of the sharp movements that occur from day to day. Trading volume is another important element of technical analysis. Trading volume refers to the number of shares traded during a particular period. If a stock's price rises while its trading volume increases significantly, investors can observe that the price increase occurred alongside greater trading activity. Some investors interpret this combination as a sign that an upward trend is strengthening. However, increasing trading volume does not guarantee that the stock price will continue rising. Because every completed trade involves both a buyer and a seller, heavy trading alone cannot establish which side will ultimately benefit. Technical analysis also includes the concepts of support and resistance. Imagine that a stock repeatedly falls toward $10 but then begins rising again. Some technical analysts might identify the area around $10 as a support level. Conversely, if the stock repeatedly climbs toward $15 before falling again, the area around $15 might be considered a resistance level. However, support and resistance levels are not barriers that stock prices must obey. Unexpected bad news could cause a stock to fall well below its support level. Likewise, favorable developments could send its price sharply above a resistance level. So which approach is more accurate, fundamental analysis or technical analysis? Unfortunately, neither method can be considered consistently more accurate in every situation. Fundamental analysis helps investors understand what a company does and how much profit it might generate. However, even if an investor estimates a company's value accurately, it can be difficult to predict when the market price will move toward that value. Technical analysis helps investors study how trading activity is reflected in market prices. However, there is no guarantee that patterns observed in the past will repeat in the future. For example, even if fundamental analysis suggests that a stock is undervalued, an economic recession could cause its price to decline for an extended period. Similarly, a stock might show a strong upward trend on a chart but suddenly fall when the company reports unexpectedly poor financial results. For this reason, some investors use both approaches together. They might use fundamental analysis to decide which companies to invest in and technical analysis to help determine when to buy or sell their shares. Of course, combining the two approaches does not make future stock prices predictable with certainty. Investors choose different analytical methods because their financial goals, investment horizons, and tolerance for risk differ. Some investors focus on the long-term growth of businesses, while others pay closer attention to price movements over shorter periods. Regardless of which approach they use, however, there is one important fact that investors should remember: no one can know a stock's future price with certainty. Ultimately, fundamental analysis is an attempt to understand the value and future prospects of a company, while technical analysis is an attempt to understand how prices behave in the market. Although the two approaches begin with different questions, both have developed as ways to make more informed decisions about an uncertain future. The important thing is not to believe unquestioningly in any particular method, but to understand what that method can reveal and what it cannot.