Most investors are often clueless when investing in stocks because they have yet to learn that analyzing the stocks is necessary. Instead, many invest based on what’s trending or follow another trader friend’s suggestion to put money. It is one of the worse ways to support if you are looking for long-term sustainable wealth.
Are stocks analyzed? In fact, the question “How to analyze stocks before investing?” ranks as one of the top-rated searches on most leading search engines, including Google.
To answer the oft-repeated question, yes, stocks must be analyzed before investing in them. Investors use two types of Analysis: Fundamental Analysis and Technical Analysis.
What is Fundamental and Technical Analysis: Key Differences?
Fundamental Analysis and Technical Analysis are investing strategies that are poles apart. They are two different approaches investors use in the stock market.
Both these methods are very distinct, and they contradict each other. Many investors have often argued which of these investing methods is best for analyzing a stock. The main aim of both these methods is to help the researcher predict the stock’s future price. However, their strategies and the tools used to reach conclusions are different.
Fundamental Analysis of stocks looks at all the factors that will impact the Company’s stock price. For example, they note the financial statements, management progress, industry, and cash flow based on the economy. Doing so lets you know the Company’s intrinsic value, which can be used to identify whether the stock price is undervalued or overpriced.
Whereas the technical Analysis is based on internal market data such as charts, patterns, trading volume, and trends in price movements. Market trends and patterns tend to repeat often, and technical Analysis helps you identify these trends in the market. The data is also used to determine price movements in the future.
|Benjamin Graham and David Dodd introduced fundamental analysis in 1934
|Charles Dow and the Dow Theory in the late 1800s introduced technical analysis
|Candlestick analysis is the oldest. It was invented by a Japanese grain trader.
|What is it for
|Fundamental Analysis is used for investing
|Technical Analysis is used for trading in the stock market
|Types of Analysis
|Qualitative and Quantitative
|Chart patterns and statistical indicators
|Who uses it
|Long-term investors who look at the intrinsic value of the stock use it
|Traders interested in short-term price movements and immediate gains use it.
|Why use it
|To understand if the asset is under-or-over priced
|To find the right time to enter and exit the market
|It is used chiefly for Equity investments but can also work for bonds and derivates.
|It can be used for all assets.
|Information used to decide
|The decision is based on financial statements, press releases, balance sheets, etc.
|The decision is made based on trade volume and price.
|Time of Analysis
|Long-term (years or decades)
|Short-term (Days, hours)
The Objective of Fundamental and Technical Analysis of Stocks
Fundamental Analysis of stocks is a time-tested strategy to create sustainable wealth. In contrast, traders looking to make quick gains through short-term investing prefer technical Analysis. Let us understand this with an example shared below.
Mahesh and Sagar are colleagues who started their stock investments together in 2011. Mahesh is a long-term investor who uses fundamental Analysis to evaluate stocks before investing. He is a patient investor and an avid reader of books on investing, and he firmly believes that fundamental Analysis is the best way to invest in the stock market. As a result, he identified and invested early in potential multibaggers that turned his initial investment of 3 lacs into 30 lakh rupees over ten years.
On the other hand, his colleague Sagar believed in short-term investing. So he used technical Analysis to start investing in the stock market with an investment of 3 lakh rupees at the same time as Mahesh. However, after ten years in the stock market, the total value of his investment is still around 3 lakh rupees. While Sagar did make some gains initially, his early gains were quickly wiped out due to recurring losses. To make matters worse, high brokerage charges due to frequent buying and selling had also reduced his profits considerably.
The objective of both fundamental Analysis and Technical Analysis is to research and forecast future trends in stock prices, and both these methods of Analysis have their advantages and disadvantages.
Fundamental Analysis v/s Technical Analysis of Stock. Which is better?
Fundamental Analysis measures the intrinsic value of a stock by studying the financial condition of a company, its management, the overall economy, and the sector in which it operates. Fundamental Analysis often uses data from the cash flow, earnings, expenses, earnings per share, profits, assets, liabilities, debt, dividends, and estimated growth in the earnings rate. It determines a stock’s real or fair market value. If the stock’s real value is higher than the market price, the stock is deemed undervalued and hence offers a good value proposition.
On the other hand, technical Analysis focuses on studying the historical price trends of the stock. In technical Analysis of stocks, no attempt is made to measure a stock’s intrinsic value. Instead, the focus is on stock charts to identify patterns and trends that suggest a stock price’s future movements. The main parameters in technical Analysis are the stock’s price and volume. Some of the most popular technical analysis forms are support and resistance, trend lines, and simple moving averages.
However, there is no clear winner in this debate. Many use both these approaches, but it serves different purposes for different people.
How to analyze stocks using fundamental Analysis?
While a company’s income statements, cash flow, balance sheets and other publicly available data are crucial to analyze its financial health. You must also consider the economic factors affecting the market and the overall industry in which the Company operates. The goal is to identify businesses trading below their intrinsic value.
Here are a few key ratios which can help you in the fundamental Analysis of stock market investments:
This is a crucial ratio to evaluate the market value of a stock in comparison with the Company’s earnings. It reveals how much price the market is willing to pay for a stock based on its past or expected earnings in future.
The P/B ratio denotes whether a stock is overpriced or underrated by comparing the Company’s net assets with the price of its outstanding shares.
Free cash flow
Free cash flow is the cash a company produces through its operations minus expenditures. It reveals the efficiency of a company in generating money and helps an investor to determine whether the business has enough cash for dividends and share buybacks.
Check for Debt
A company’s debt levels matter greatly, as it cannot perform well with high debt on its books. Therefore, avoid investing in companies with massive debt, even if they have bright prospects.
Analyze the prospects of the Company.
This is a critical factor to consider. Investing in a company with long prospects is strongly advisable. An investor should always look at those companies invest whose products or services will have an ever-growing demand.
“How to analyze stocks before investing?” is one the most common question which rages across investors’ minds in the stock market. The above pointers should effectively resolve all your queries regarding analyzing stocks before investing in stock market. Careful evaluation of a company’s fundamentals can tell you much about a stock and how you can expect it to perform. Accurate fundamental Analysis can help multiply your returns from the stock market and substantially reduce the risk associated with equity investment.
Advantages and Disadvantages of fundamental and technical Analysis
Fundamental Analysis of Stocks
Advantages of Fundamental Analysis
- Fundamental Analysis is an effective strategy for identifying and investing in stocks that represent a good value while investing long-term to achieve capital appreciation.
- One of the most incredible benefits of fundamental Analysis is that an investor develops a strong understanding of the business and industry due to the detailed and extensive research and study involved.
Disadvantages of Fundamental Analysis
- The actual or fair value of a stock is based on assumptions. Therefore, sudden or unexpected changes in the stock’s fundamentals can significantly alter the analysis results.
- Fundamental Analysis can help you identify an undervalued company but does not indicate the right time to invest in a stock. Simply put, even if an investor finds a stock trading below its intrinsic value, it may remain at those levels for a considerable time before meeting the investor’s expectations for near-term growth.
Technical Analysis of Stocks
Advantages of Technical Analysis
- Fundamental Analysis and Technical Analysis require considerable data. Here technical analysis scores over fundamental Analysis as the required data is considerably less.
- While using technical Analysis, it is easier for investors to time the entries and exits for trades as it is mainly focused on identifying new trends and reversals in trends.
Disadvantages of technical analysis
- The drawbacks of Technical Analysis include mixed signals, where two different indicators may indicate contradictory information. For example, while one indicator could indicate a buy, the other could indicate a sell leading to confusion.
- Technical signals generated may often suffer from a time lag, confusing the trader. The price action could be over when the trader gets a clear call.
- Technical Analysis may only be able to predict future trends sometimes due to high volatility in the market. As a result, an investor can never generate consistent returns with technical Analysis to build sustainable wealth.
Key Ratios Used While Doing Fundamental Analysis of Stocks
Fundamental Analysis of stocks is one of the best ways to screen and select stocks while investing. It is a well-known fact that successful investors like Warren Buffet, Peter Lynch, Charlie Munger and Rakesh Jhunjhunwala have used fundamental Analysis of stocks to invest and create huge fortunes.
The price-to-earnings ratio is a critical ratio used in the fundamental Analysis of stocks, as it can help you determine the market value of a stock compared to the Company’s earnings. It shows what the market will pay today for a stock based on its past or future earnings.
To know the ideal P/E ratio, you can also compare the current P/E with the Company’s historical P/E, the industry and market P/E.
Price-to-Book Value Ratio
The price-to-book ratio or P/BV ratio measures whether a stock is over or undervalued by comparing a company’s net assets to the price of all the outstanding shares.
A P/BV ratio of less than one (=<1 ) means that the stock is undervalued and the value of assets on the Company’s books is more than the value the market assigns.
Free cash flow
Free cash flow refers to the cash produced by a company through its operations after deducting the cost of expenditures. It shows how efficient a company is at generating cash and is an important measure to determine if it has sufficient cash to reward shareholders through dividends and share buybacks.
The debt-to-equity ratio (D/E) reveals how a company finances its assets. The ratio shows the proportion of equity to debt a company uses to finance its assets. A low debt-to-equity ratio means the Company uses less debt for financing than equity via shareholders. Conversely, a company with high levels of debt means high risk. It is because the Company doesn’t have the earnings or cash flow to meet its debt obligations.
Return On Equity
Return on equity (ROE) is an essential measure in the fundamental Analysis of stocks as it denotes the return shareholders get from the business and overall earnings. This is useful in comparing the profitability of companies in the same industry and is also a yardstick for measuring the management’s capability to conduct business efficiently. ROE can be calculated by dividing the net income by the shareholder equity.
Dividend yield can be calculated by dividing the dividend per share by the share price. Therefore, a high dividend yield indicates that the Company is doing well financially. A low dividend yield, however, does not mean that the Company is doing well, as many companies in the growth stage may choose to reinvest all their earnings for business expansion.
4 Fundamentals of Successful Stock Market Investing
Investing in stock markets is all about knowing where to invest when to invest, for how long to invest and when to sell. But as simple as it sounds, these questions require much effort, skill, and time to be answered correctly and, more importantly, profitably. After all, when investing in stocks, you want to earn profits and create wealth. Isn’t it?
If you want to know how to invest in stocks profitably, then understanding these four time-tested ground rules of the markets would greatly help:
1st – Never Ignore Fundamentals
The stock market is best suited for long-term investors. But failing to realize that thousands of investors want to make quick profits and get rich overnight. But importantly, in trying to do that, they need to pay more attention to the fundamentals that matter.
Like how good the business is (operationally and financially), how it is being run, is the management capable and trustworthy, and what are the business’s prospects.
A stock might be trading at a price higher than its intrinsic value, but eventually, the stock price will align itself with the actual value of the business. So, you must never ignore the fundamentals.
2nd- It’s Impossible to Predict Market movements in Short Term
Irrespective of what experts tell you, there is no way to predict the movement of stocks in the short term correctly. Too many factors and variables impact prices in the near term. However, the business fundamentals take over in the long term, and stock prices adjust to reflect actual business realities.
So, it would be best not to worry about the daily price fluctuations or what markets will do over the next week, month, or year. You don’t check the value of your real estate properties daily. So why do so with your stocks? Instead, direct all your efforts towards finding stocks of fundamentally sound businesses available at reasonable valuations. That’s what matters when it comes to successful investing.
3rd- Learn to go Against the Crowd
Think about it. If everyone in the market did the same thing, then do you think all of them would make money? The answer is NO, and there is enough proof for that.
Generally, investors buy stocks everyone else is buying, assuming that the stock must be reasonable and worth buying (since everybody is buying – bandwagon effect). Result? Since the stocks are neither properly researched nor purchased at the right price, investors make losses.
Savvy investors know that they can make money in markets only when they buy something that is out of favor (i.e., against the crowd) but which has a good chance of recovering. It is how you can invest in stocks successfully.
4th- Focus only on Long Term
If all the claims about money doubling overnight (in short-term trading) were true, everyone would have been rich by now. But that is not the case. Most successful investors have used the fundamental truth – in equity investing, chances of succeeding are higher with a long-term mindset rather than a short-term one.
Equity as an asset class has outperformed all other asset classes. Historical data proves that it can easily give average returns of 12-15% annually, but this is when you remain invested for sufficient periods.
Fundamental Analysis is one of the best and time-tested ways for wealth creation through investing in shares. However, while the technical Analysis may help traders to place some winning trades in the short term, more is needed to create sustainable wealth due to the high market volatility in the short term.
On the other hand, fundamental Analysis helps an investor invest in quality businesses that will outperform in the long run, thereby creating wealth for investors. Click to Invest in 20-25 fundamentally sound stocks chosen after detailed research by our team of experts.
Read more: About Research and Ranking