Introduction to Stock Analysis
One of the clichés of Wall Street is that fundamental analysis tells you what to buy, while technical analysis tells you when. While some money managers disagree with that characterization, it points to a deeper difference between the two approaches: fundamental analysis focuses on the performance of the company behind the stock while technical analysis focuses on the behavior of the stock. Put another way, when you’re doing fundamental analysis, you have to know which company you’re talking about. With technical analysis, you don’t; it might help, but you can do quite well without knowing about the underlying company, what it sells, or even its name. All you have to know is its symbol. To understand these concepts, let’s review the theoretical assumptions of each school of analysis. The Fundamental Perspective Fundamental analysts assume investors will buy the shares of companies that have good potential to make profits and, better yet, grow those profits every year. Based on this assumption, it makes sense to look at every significant aspect of that company’s business, from what its products or services are to how they stack up to the competition’s, how much money the company spends and owes versus how much revenue it brings in, how good management is, whether the market is growing, and the like. Fundamental analysts spend most of their time collecting and analyzing this data, comparing them to the same data on competitors, including the stock prices. These analysts also try to assess the future growth of each company’s markets and often factor in forecasts of the economy. They estimate the future earnings of each company, and use those estimates to predict the price investors are likely to pay for that company’s stock in the future. Most investors have heard some of the key analytical measures fundamental analysts use. One is a stock’s price-to-earnings ratio, or P/E ratio. To calculate it, analysts divide the current price per share of a stock by its per share net earnings, or profit. Since it’s possible to calculate the P/E ratio of the entire stock market as well as each industry group, and analysts keep track of the history of those P/E ratios, analysts use P/E ratios to determine whether a stock is relatively expensive (overvalued) or cheap (undervalued). Another key metric is a company’s estimated five-year earnings growth rate, which is the basis upon which analysts estimate the stock’s future price. The estimated five-year earnings growth rate rests on projections for the company’s competitive market position, its product pipeline, and its financial condition. A third metric combines the P/E ratio and the earnings growth rate to determine whether the stock is fairly priced or not. It’s called the PEG ratio, for the price-earnings multiple divided by the projected earnings growth rate. To illustrate, let’s take a stock with a P/E ratio of 30 and a projected five-year growth rate of 20% per year. This stock has a PEG ratio of 1.5 (30 divided by 20). Analysts who use the PEG ratio generally avoid recommending stocks with a PEG significantly above 1.0 and generally like stocks with a PEG below that number. The Technical Perspective Technical analysis is based on a widely accepted premise: the price of a stock is based on supply and demand. If, at a given price, people want to buy more of a product than the maker can produce, the price will go up, whether it’s a box of cereal, a car, or a stock. Conversely, if there’s more product in the market than people willing to buy at its current price, all things being equal, the price will drop. So, the theory goes, as long as you know the relative balance of supply and demand for a given stock at a given price, you don’t really need to know what the product is. Technical analysts say all the needed information about supply and demand can be found in the chart of a stock’s historic price movement, particularly if the chart captures the changing levels of volume with the changes in price. Yet one difference between stocks and commercial goods is the way technical analysts define supply. Companies can increase the production of manufactured goods or delivery of services at will. Not so with stocks — unless a company issues more shares, the number in the market is fairly stable. The supply of shares of stock, from a technical analyst’s point of view, is the number of shares already owned by the public that are being brought to the market for sale by brokers. To illustrate, technical analysts interpret an upward move in a stock price, combined with higher volume the previous day, as an indication that there is a larger number of buyers (demand) than sellers at the current price, and potential sellers are holding out for a higher price. Conversely, a downward move on higher volume means there are more sellers eager to sell shares than there are buyers willing to pay the current price. Unlike fundamental analysts, technical analysts generally don’t make predictions of future stock prices. Instead, they try to identify prices that serve either as resistance against any higher movement or support against a further loss in price. The reason these price points exist is because most investors remember what they paid for a stock and base their decision to sell by comparing the current price with what they paid. For example, it’s human nature to avoid a loss. So, if a stock that has risen in price comes back down to the price an investor paid, he/she may be reluctant to sell, but once it falls below that price, he may be eager to sell right away. By the same token, many investors — particularly professionals — know the price at which a stock peaked. As the stock approaches that price again, investors may begin to sell in order to lock in their profits. This shift toward more sellers than buyers may make that price another resistance point from which the stock declines again. Technical analysts find many different ways to identify points of resistance and support. They can be found in peaks and valleys in the line that connects a stock’s closing price over time. They can also be found in prices against which the stock has repeatedly bounced from in either direction, or in lines that connect a series of price bottoms or tops, called trend lines. What Works for You? Traditionally, more professional investors and advisers have relied on fundamental stock analysis than technical, particularly when the investor is in the market for the long term. But a large and growing number have found both fundamental and technical analysis provide insights that are useful in determining which stocks to buy and when.
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