Meaning of fundamental analysis
Fundamental analysis is method of finding out the future price of a stock which an investor wishes to buy. Fundamental analysis is used to determine the intrinsic value of the share of a company to find out whether it is overpriced or under priced by examining the underlying forces that affect the well being of the economy, Industry groups and companies.
Fundamental analysis is simply an examination of future earnings potential of a company, by looking into various factors that impact the performance of the company. The prime objective of a fundamental analysis is to value the stock and accordingly buy and sell the stocks on the basis of its valuation in the market. The fundamental analysis consists of economic, industry and company analysis. This approach is sometimes referred to as a top-down method of analysis.
Types of financial analysis to be done before making Investment
The actual value of a security, as opposed to its market price or book value is called intrinsic value. The intrinsic value includes other variables such as brand name, trademarks, and copyrights that are often difficult to calculate and sometimes not accurately reflected in the market price. One way to look at it is that the market capitalization is the price (i.e. what investors are willing to pay for the company and intrinsic value is the value (i.e. what the company is really worth). The fundamental analysis consists of economic, industry and company analysis. This approach is sometimes referred to as a top-down method of analysis.
a) At the economy level, fundamental analysis focus on economic data (such as GDP, Foreign exchange and Inflation etc.) to assess the present and future growth of the economy.
b) At the industry level, fundamental analysis examines the supply and demand forces for the products offered.
c) At the company level, fundamental analysis examines the financial data (such as balance sheet, income statement and cash flow statement etc.), management, business concept and competition.
a) ECONOMIC ANALYSIS: Economic analysis occupies the first place in the financial analysis top down approach. When the economy is having sustainable growth, then the industry group (Sectors) and companies will get benefit and grow faster. The analysis of macroeconomic environment is essential to understand the behavior of the stock prices. The commonly analysed macro economic factors are as follows:
a) gross domestic product (GDP) growth rate
b) exchange rates
c) balance of payments (BOP)
d) current account deficit
e) government policy (fiscal and monetary policy)
f) domestic legislation (laws and regulations)
g) unemployment rates
h) public attitude (consumer confidence)
j) interest rates
k) productivity (output per worker)
l) capacity utilisation (output by the firm).
b) INDUSTRY OR SECTOR ANALYSIS: The second step in the fundamental analysis of securities is Industry analysis. An industry or sector is a group of firms that have similar technological structure of production and produce similar products. These industries are classified according to their reactions to the different phases of the business cycle. They are classified into growth, cyclical, defensive and cyclical growth industry. A market assessment tool designed to provide a business with an idea of the complexity of a particular industry. Industry analysis involves reviewing the economic, political and market factors that influence the way the industry develops. Major factors can include the power wielded by suppliers and buyers, the condition of competitors and the likelihood of new market entrants. The industry analysis should take into account the following factors.
a) Characteristics of the industry
b) Demand and market for the product.
c) Government policy
d) Labour and other industrial problems exist or not.
e) Capabilities of management.
f) Future prospects of the industry
c) COMPANY OR CORPORATE ANALYSIS: Company analysis is a study of variables that influence the future of a firm both qualitatively and quantitatively. It is a method of assessing the competitive position of a firm, its earning and profitability, the efficiency with which it operates its financial position and its future with respect to earning of its shareholders. This analysis can be done with the held of financial statements.
Financial statement means a statement or document which explains necessary financial information. Financial statements express the financial position of a business at the end of accounting period (Balance Sheet) and result of its operations performed during the year (Profit and Loss Account). In order to determine whether the financial or operational performance of company is satisfactory or not, the financial data are analyzed. Different methods are used for this purpose. The main techniques of financial analysis are:
1) Comparative Financial Statements: In comparative financial statement, the financial statements of two periods are kept by side so that they can be compared. By preparing comparative statement the nature and quantum of change in different items can be calculated and it also helps in future estimates.
2) Trend Analysis: In order to compare the financial statements of various years trend percentages are significant. Trend analysis helps in future forecast of various items on the basis of the data of previous years. Under this method one year is taken as base year and on its basis the ratios in percentage for other years are calculated.
3) Common Size Statement: Common size financial statements are such statements in which items of the financial statements are converted in percentage on the basis of common base. In common size Income Statement, net sales may be considered as 100 percent. Other items are converted as its proportion. Similarly, for the Balance sheet items total assets or total liabilities may be taken as 100 percent and proportion of other items to this total can be calculated in percentage.
4) Fund Flow Statement: Fund Flow Statement is prepared to find out financial changes between two dates. It is a technique of analyzing financial statements. With the help of this statement, the amount of change in the funds of a business between two dates and reasons thereof can be ascertained. The investor could see clearly the amount of funds generated or lost in operations.
5) Cash Flow Statement: The cash flow statement expresses the reasons of change in cash balances of company between two dates. It provides a summary of stocks of cash and uses of cash in the organization. With the help of cash flow statement the investor can review the cash movement over an operating cycle. The factors responsible for the reduction of cash balances in spite of increase in profits or vice versa can be found out.
6) Ratio Analysis: Ratio is a relationship between two figures expressed mathematically. It is quantitative relationship between two items for the purpose of comparison. Ratio analysis is a technique of analyzing financial statements. It helps in estimating financial soundness or weakness. Ratios present the relationships between items presented in profit and loss account and balance sheet. It summaries the data for easy understanding, comparison and interpretation.
Meaning of technical analysis
In fundamental analysis, a value of a stock is predicted with risk-return framework based on economic environment. An alternative approach to predict stock price behaviour is known as technical analysis. It is frequently used as a supplement rather than as a substitute to fundamental analysis. Technical analysis is based on notion that security prices are determined by the supply of and demand for securities. It uses historical financial data on charts to find meaningful patterns, and using the patterns to predict future prices.
In the words of Edwards and Magee: “Technical analysis is directed towards predicting the price of a security. The price at which a buyer and seller settle a deal is considered to be the one precise figure which synthesizes, weights and finally expresses all factors, rational and irrational quantifiable and non-quantifiable and is the only figure that counts”.
Tools of Technical Analysis:
Charting represents a key activity for a technical analyst during individual stock analysis. The probable future performance of a stock can be predicted and evolving and changing patterns of price behaviour can be detected based on historical price-volume information of the stock. Charts used to study the trend in prices, price index, and also volume of transactions. Technical analysis involves three basic types of charts. They are (a) Line charts, (b) Bar charts, and (3) Point and figure charts.
a) A Line Chart connects successive trading day’s closing price/price indices or volume of trade as the case may. Each day’s price is recorded.
b) A Bar Chart is made up by a series of vertical bars of lines, each bar of line representing, a particular day’s high and low prices. The closing price of a day is indicated by a small horizontal dash on the day’s bar. Each day’s price data are thus recorded.
c) Point and figure charts are more complex than line and bar charts. Point and figure chart are not only used to detect reversals in a trend, but also used to forecasts the price, called price targets. The only significant price changes are posted to point and figure charts. Three or five point price changes as posted for high prices securities, only one point changes are posted follow prices securities. While line and bar charts have two dimensions with vertical column indicating trading day, point and figure chart represents each column as a significant reversals instead of a trading day. For example, for a share in the price hand of Rs. 1000-1500 or so, a price change exceeding, say, Rs. 15 may be taken as significant, whereas for a scrip in the price range of Rs. 100-150, a change in price of the order of Rs. 3 or more may be taken as significant. Upward significant moves are indicated by ‘x’ in the same column. Say for scrip of Rs. 3 change is taken as significant. Another ‘x’ in the same column, above the previous ‘x’ is put. The same day it moves to 107. One more ‘X’ is put. Next day price drifts by Rs. 2. No entry in price will he recorded in this column. If a significant increase in price takes place, next column of ‘x’ will be charted.
Theory of technical analysis - Dow Theory
The ideas of Charles H. Dow, the first editor of the Wall Street Journal, form the basis of technical analysis today. According to the hypothesis of Dow, the stock market does not perform on random basis but is influenced by three cyclical trends, namely, (a) Primary trend, (b) secondary or intermediate trend, and (3) Tertiary or minor trend. The general market direction can be predicted by following these trends. The primary trends are the long-term movement of prices, lasting from several months to several years. They are commonly called bear or bull markets. Secondary trends are caused by short-term deviations of prices from the underlying trend line. They last only a few months. The secondary trend acts as a restraining force on the primary trend, tending to correct deviations from its general boundaries. Minor trends are daily fluctuations in either directions (bull or bear) which are of little analytical value. In terms of bull and bear markets the trends are described as follows:
• The first phase of a bull market is the accumulation phase. This is when prices are depressed and financial reports don't look good. However, farsighted investors use this period of depressed prices to take advantage and buy shares.
• The second phase of the bull market is characterized by increased activity, rising prices, and better financial reports. This is the period where the large gains are made. At this point, the market becomes vulnerable to a reversal.
• The first phase of a bear market is the distribution phase. This is where farsighted investors see the uninformed investors scrambling to buy shares. The farsighted investors begin to sell shares. Oversupply leads to weakening prices and profits are harder to come by.
• The second phase of the bear market is characterized by near panic selling. Prices accelerate to the downside and more and more people begin to liquidate their holdings.
• The third phase of the bear market is characterized by further weakening and erosion of prices. Lesser quality issues erase the gains of the previous bull market. The news is full of bad market news.
The second part of the Dow Theory is that the Industrial Average and the Railroad Average must corroborate each other's direction for there to be a reliable market direction signal. Dow created the Industrial Average, of top blue chip stocks, and a second average of top railroad stocks (now the Transport Average). He believed that the behavior of the averages reflected the hopes and fears of the entire market. The behavior patterns that he observed apply to markets throughout the world.
According to Dow theory, large active stocks will generally reflect the market averages. However, individual issues may deviate from the broad averages because of circumstances peculiar to them. The logic behind the makeup of the specific averages is that both the industrials and the transports are independent of each other. Yet, for the industrials to get their products to market, they must use the transports. When the industrials are doing well, the transports will do well. However, when one sector is doing substantially better than the other, a divergence is taking place. This demonstrates that one sector is much stronger than the other; and if it continues, without the other sector catching up, a major reversal in the market will take place.
Dow Theory also specifies that closing prices should only be used. This is because closing prices reflect the price level at which informed investors are willing to carry positions overnight. Thus, Dow theory is used to indicate reversals and trends in the markets as well as individual security. The basic tenet of Dow theory is that there is a positive relationship between trend and volume of shares traded.
Assumptions of technical analysis:
Edwards and Magee formulate the basic assumptions underlying technical analysis which are as follows:
1. The market value of the scrip is determined by the interaction of demand and supply.
2. Supply and demand is governed by numerous factors, both rational and irrational. These factors include economic variables relied by the fundamental analysis as well as opinions, moods and guesses.
3. The market discounts everything. The price of the security quoted represents the hope, fears and inside information received by the market players. Insider information regarding the issuance of bonus shares and right issues may support the prices. The loss of earnings and information regarding the forthcoming labor problem may result in fall in price. These factors may cause a shift in demand and supply, changing the direction of trends.
4. The market always moves in the trends except for minor deviations.
5. It is known fact that history repeats itself. It is true to stock market also. In the rising market, investors’ psychology has upbeats and they purchase the shares in great volumes driving the prices higher. At the same time in the down trend, they may be very eager to get out of the market by selling them and thus plunging the share price further. The market technicians assume that past prices predict the future.
6. As the market always moves in trends, analysis of past market data can be used to predict future price behavior.
7. Shift in demand and supply, no matter when and why they occur, can be detected through charts prepared specially to show market action.
8. Changes in trends in stock prices are caused whenever there is a shift in the demand and supply factors.
Difference between technical and fundamental analysis
The key differences between technical analysis and fundamental analysis are as follows:
1. Technical analysis mainly seeks to predict short term price movements, whereas fundamental analysis tries to establish long term values.
2. The focus of technical analysis is mainly on internal market data, particularly price and volume data. The focus of fundamental analysis is on fundamental factors relating to the economy, the industry, and the firm.
3. Technical analysis appeals mostly to short-term traders i.e. speculators, whereas fundamental analysis appeals primarily to long-term investors.
4. Technical analysis is the a simple and quick method on forecasting behaviour of stock prices. Whereas, fundamental analysis involves compilation and analysis of huge amount of data and is therefore, complex, time consuming and tedious in nature.
5. The technical analysis is based on the premise that the history repeats itself. Therefore, the technical analysis answers the question “What had happened in the market” while on the basis of potentialities of market fundamental analysis answers the question, “What will happen in the market”.
6. The technical analysis assumes that the market is 90 percent psychological and 10 percent logical, while the fundamental analysis believes that the market is 90 percent logical and 10percent psychological.
7. The technical analysis seeks to estimate security prices rather than values, while the fundamental analysis estimates the intrinsic value of a security.
8. According to technical analysts, their method is far superior than the fundamental analysis, because fundamental analysis is based on financial statements which themselves are plagued by certain deficiencies like subjectivity, inadequate disclosure etc.
Advantages of technical analysis
1) Simple and quick: Technical analysis is simple and quick method on forecasting behaviour of stock prices.
2) Helps in identifying trend: Under the influence of crowd psychology, trends persist for quite some time. Tools of technical analysis that help in identifying these trends early are helpful in investment decision-making.
3) Short term price prediction: Technical analysis try to predict short term market price which is useful for speculators who want to make quick money.
4) Tracking shift in demand and supply: Shifts in demand and supply are gradual, not instant. Technical analysis helps in detecting these shifts rather early and hence provides clues to future price movements,
5) Price movement analysis: Fundamental information about a company is absorbed and assimilated by the market over the period of time. Hence, the price movement tends to continue in more or less in the same direction till the information is fully assimilated in the market.
6) Price prediction: Charts provide a picture of what has happened in the past and hence give a sense of volatility that can be expected from the stock. Further, the information on trading volume, which is ordinarily provided at the bottom of a bar chart, gives a fair idea of the extent of public interest in the stock.
7) Superior than fundamental analysis: According to technical analysts, their method is far superior than the fundamental analysis, because fundamental analysis is based on financial statements which themselves are plagued by certain deficiencies like subjectivity, inadequate disclosure etc.
Limitations of technical analysis
1) Past and historical data: Technical analysis is based on the past and historical data. Unexpected future are not taken into consideration by it.
2) Analyst Bias: Just as with fundamental analysis, technical analysis is subjective and our personal biases can be reflected in the analysis.
3) No explanation about the tools used: Most technical analysts are not able to offer convincing explanations for the tools employed by them.
4) Chances of wrong decision: False signals can always occur in the stock markets. If the technical analysts act without confirmation, they would make mistakes and would suffer unnecessary expenses and losses.
5) Limited use of technical analysis: Empirical evidence in support of the random walk hypothesis casts its shadow over the usefulness of technical analysis.
6) Delay: By the time an up trend or downtrend may have been signaled by the technical analysis, may already have taken place.
7) Commonly used system: Ultimately, technical analysis must be a self-defeating proposition. As more and more people employ it, the value of such analysis tends to decline.
8) Different interpretation by different analyst: There is a great deal of ambiguity in the identification of configurations as well as trend lines and channels on the charts. The same chart can be interpreted differently.
Despite these limitations, technical analysis is very popular. It is only in the rational, efficient and well ordered market where technical analysis has no use. But given the imperfections, inefficiencies and irrationalities that characterize real markets, technical analysis can be helpful. Hence, it can be concluded that technical analysis may be used, albeit to a limited extent, in conjunction with fundamental analysis to guide investment decision-making, as it is supplementary to fundamental analysis rather than substitute for it.