Fundamental or Technical Analysis: Which is better?
If you have a background in accounting or finance, fundamental analysis will be second nature to you. Technical analysis, on the other hand, requires a separate level of skill set and is used by traders who track movements in prices in the stock market.
When it comes to making investment decisions, there are two main forms of analysis that can be carried out and they include: Fundamental analysis and Technical analysis.
With fundamental analysis, the investor takes a logical, pragmatic approach to investing to assess the financial soundness of a company as well as its business prospects. However, technical analysis takes on a more psychological approach where an investor focuses on analysing past market movements in the company’s stock to forecast future movements in prices.
If you have a background in accounting or finance, fundamental analysis will be second nature to you. Technical analysis, on the other hand, requires a separate level of skill set and is often used by traders who track daily movements in prices in the stock market, commodity market, or even forex market. Here’s what both entail:
Fundamental Analysis
There are a number of metrics to use in fundamental analysis to decide where to invest these include:
Revenue
This is a very important metric in fundamental analysis. It is the amount of sales a company has made over a set period of time. The focus of the analysis is on the direction of revenues - on whether it is rising or falling.
It can be as simple as examining the true reason for the rise of sales in a specific month to find out if it is based on a strategy or just a seasonal change.
Earnings Per Share (EPS)
Although the revenue base of a company is important, earnings (profit) serves as a real determinant of success. One clear reason for this is that even if the sales of a company is rising, if it cannot be translated to profits, then something is wrong.
It could be that the company has excessive expenses, poor management, etc. The EPS simply tracks the potential earnings per a single unit of shares in a company.
Price to Earnings Ratio (P/E Ratio)
Another great tool for fundamental analysis is the P/E ratio and it is simply computed by dividing the current stock price by its annual earnings per share. When analysts refer to a company’s valuation, they are often referring to its P/E ratio.
In defining a good P/E, there is no “one size fits all”, because it varies by sector. Analysts often disagree on what constitutes a cheap stock because there is so much debate about what a specific P/E ratio actually means for a given company or industry.
Sector Fundamentals
A single company’s performance can be heavily influenced by the sector in which it operates. During economic slowdowns, fast moving consumer goods (FMCGs) and utilities tend to do better, whereas technology, transportation and financials do better when the economy is on an upswing.
Technical Analysis
Charts are the main instruments used in technical analysis and some of the chart-watching basics involved in technical analysis include:
Price Trends
This takes a look at the trading prices of the stocks of a company. It is used to answer questions such as: Is the price of the stock moving higher or lower? How long has it been doing so?
Some investors who employ this method only buy securities that are in uptrends. They may wait for a short-term downtrend to enter, but won’t even consider the stock if the longer-term trend is lower.
Moving Averages
An important method with which chart-readers analyse market positions is in adding moving average lines to a chart to determine the overall trend direction. A moving average line simply plots the average price of a security over a set period of time.
Some investors like to buy when the moving average is trending upward and the price pulls back a touch to allow for a good “entry point” into the stock.
Which Is Better?
For decades, fundamental analysis was the only investment method that was given any credibility. However, the advent of data processing and financial technology has made technical analysis easier and more widely available.
Many of the largest market players are making their trading decisions based on algorithms and use computer modelling to determine their entry and exit points.
Today, investments are moving based on technical factors as much as fundamental ones.
The best approach to investing likely involves some combination of fundamental and technical analysis. In essence, it is good to choose stocks or sectors that have strong fundamentals and then use technical analysis to help me decide when to buy or sell them.
Written by Lawretta Egba