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, maximising 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 investigation 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 utilises a pragmatic, logical approach towards investing whereas technical analysis helps in to understand the psychology of the market.
While both these financial analysis and investment decision-making 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 school 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?
The fundamental analysis aims towards finding the value of a company. This implies the computation of the Intrinsic price of the company. It utilises economic factors to determine the value of the business and its stock. Investors who opt for the route of fundamental analysis, investors analyse the following factors.
- Revenue
The can be accounted as 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 analysed. 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 fundamental of any business. In case a company has increased sales but is experiencing declining profitability or even losses, it is a matter of concern. This can indicate expenditure exceeding revenues and poor management. Investors desire to invest in companies which increasing margins and hence an EPS growth is an important indicator of a company’s financial performance.
- P/E Ratio
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 analysing the growth prospects of a company and how much higher should one pay over the existing earnings of the company to acquire its stock.
- Sector Fundamentals
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%.
- Industry Analysis
The analysis of the prevailing macroeconomic conditions and climate 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 analyse 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 utilised 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 utilised in the technical analysis include:
- Price Trends
This involves tracking the movement of stock prices to analyse whether a stock price is increasing or decreasing, and how long has this trend going on. This helps investors in making investment decisions such as buying shares during a temporary downtrend, investing in shares with increasing prices etc.
- Volume
While charts and trend may act as an ink blot test of a market, the volume acts as its lie detector. Trading volumes can provide indication about the strength of a trend and the possibility of its reversal.
- Moving Averages
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.
- Indicators
A wide array of technical indicators are often 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 the analyst.
Conclusion
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 technical analysis easy to conduct and widely available. Many investors and firms utilise computer modelling, black box trading etc. towards determining their points of entry and exit.
But investment decision is being made on technical and well as fundamental factors. Hence, rather than debating which technique is better, it is best to utilise both techniques and experience the best of both worlds. Investors can select stocks and sectors with strong fundamentals and utilise technical analysis towards making their investment decisions towards investing in a certain stock.