Fundamental versus technical analysis

When you are watching a business channel you might have come across experts showing charts and using words like resistance, support level, and breakout etc. Or they might have read a column written by an expert in a business daily discussing fundamentals about companies and  giving a buy or sell recommendation on any stock, based on PE ratio, Return on Equity (ROE) etc.

These are just two approaches to analysing equity stocks and investing in them. The expert who was using charts was using Technical Analysis and the expert  who was explaining ratios was using Fundamental Analysis. 

Here’s a lowdown on both the approaches: 

 

Technical analysis

Technical analysis believes that the market price of a stock or the trading volumes reflect all information about the company and so fundamental information like cash flows, profitability, PE ratio, etc are of irrelevant and instead uses inputs like past price, volume and time. The price of a stock is plotted on a graph to see if any pattern or trend can be detected.

While using volumes, if there is an unusual build up in volumes during a period, it could point to some important developments in the company — good or bad. Since they study charts, technical analysts are called as ‘chartists’.

The technical analyst is like the palmist who predicts the future of a person by reading the lines on the palm of a person. The technical analyst sees patterns in the charts and predicts support, resistance and breakout levels of a stock. A technical analysis believes that ‘Trend is a friend’. Based on patterns or trends, a buy or a sell recommendation is given. Since the recommendations are for short periods like a day or a week this is ideal for a day trader or a speculator and not for a long-term investor.

Fundamental analysis

Fundamental analysis on the other hand involves studying the fundamentals of the company. It may also look beyond a company and study developments in the industry and the economy. It also takes in to account other factors like quality or pedigree of promoters and management, the business they are in, the time they are in etc. Fundamental analysis involves studying ratios like EPS, PE Ratio, Price to Book Value ratio, cash flow, return on equity, return on capital employed etc.

Based on the ratios, a fundamental analyst arrives at the intrinsic value of a stock and compares it with the market price to conclude whether the stock price is overvalued or undervalued and recommend whether the stock should be bought or sold. For a fundamental analyst when an investor buys shares of a company, he is indeed becoming an owner in that company by buying a slice of the business of that company. Since the investor will own the company to the extent of the shares that he buys, he should stay invested for many years and not just for days or weeks.

We will try to understand a few important ratios used in Fundamental analysis.

Earnings per share

Earnings per Share (EPS) is a measure of a company’s profitability and is calculated by dividing net profit by the number of outstanding shares. So higher the EPS, more are the profits and better are the prospects of the company. A consistent increase in EPS over a period of time is a healthy sign. You may use either the Basic or Diluted EPS.

PE Ratio

PE Ratio is the most popular and widely used ratios by investors. It is calculated by dividing Market price of the stock by its EPS. Also called as the PE multiple, it shows the price the investor is willing to pay to get the earnings. Based on the PE Ratio and the industry PE, a stock is said to be either cheap or expensive. Again both historical (Trailing) and forward PE may be used while taking a decision.

Return on Equity (ROE)

ROE is a very important profitability metrics used in fundamental analysis and measures how effectively a company is using or deploying the shareholder funds in business in generating profits. It is calculated by dividing net profit by shareholder funds. Taking the current yield of 7.50% on a 10-year G-Sec as the risk free return, anything in excess of 15% should be considered as very good.

While technical analysis is for day traders, fundamental analysis is useful for long-term investors. Some of the stocks (in the table given below) have given extraordinary returns in the past one year.

(The writer is a former banker, and is currently teaching at Manipal Academy of Banking in Bengaluru)