Fundamental Analysis is the research on determinants of stock value, such as earnings and dividends prospects, expectations for future interest rates, and risk of the firms. This type of analysis takes into account the earnings and dividend projections of the firm in question, outlook of future interest rates, and risk assessment of that firm to establish correct stock prices. At the end of the day, it represents an effort to establish the present discounted value of all the payments a stockholder will be given from each share of stock. If that value were more than the stock price, then that stock would be worth purchasing in view of the fundamental analyst.
Fundamental analysts typically begin their work by studying the past record of earnings and an assessment of company balance sheets. A supplementary comprehensive economic analysis, an assessment of the quality of the company’s management, that company’s footing within its industry, and the forecast of the industry as one, is then made. These analysts essentially aim to gain some insight into how the firm is likely to perform in future with a hope that such insight is yet not attained by the rest of the market.
The efficient market hypothesis holds the notion that typically speaking fundamental analysis brings little value. This is for the fact that any firm’s earnings and industry information are freely accessible to everyone, and therefore every analyst has hands on such information. As such it is inconceivable that the assessment and valuation of a particular firm’s prospects, made by different analysts would vary. Many such firms that have access to timely and quality information and have sufficient finances to keep running are making this kind of market research. Due to this yet another fact it becomes difficult to believe that any analyst can unearth data that other analysts have not already discovered. If an analyst has to succeed and stand out, he or she needs to have a matchless and incomparable approach.
Fundamental analysis is not only about discovering such firms that are efficiently managed and have strong prospects, there is more to it. If it so that the whole market is already aware of a good firm or a good investment, then such discovery is not apt to bring any gain for a particular investor or analyst. The reason for this is that publicly available knowledge about a good firm boosts the price of the investment in that firm and hence yields a less than superior return.
Good fundamental analysts do not aim to find firms or companies that are good investments but they actually tend to identify such firms or companies that superior than what everyone else has estimated to be. Such efforts make it difficult to run fundamental analysis. Making a good analysis does not suffice; a good fundamental analyst has to outsmart his competitors for the reason that the prevalent market prices is known to already be a sign of all generally available information.
To determine a proper price for a firm’s stock, the security analyst must forecast the dividends and earnings that can be expected from the firm. And this is exactly what is central to this type of analysis. Such projections of firm’s earnings and dividends are imperative in establishing the value of that firm. After all, it is the business success that a firm attains which decides upon its volume of earnings and ultimate payouts in form of dividends to its shareholders. The market price of that firm’s stock can eventually be determined on the basis of all this. It cannot be denied that any firm’s prospects are closely associated with the prospects of the economy in general. Thus while making valuation analysis; the economic environment must be taken into account.
When studying a firm’s prospects with an aim to make analysis, it is most suitable that the broader economic environment is studied first, both that of international as well as domestic. Such outside environments caste effects on the industry that the firm makes part of. There onward the analyst examines the firm within that industry.
When analyzing the prospects of a firm, a top-down approach suggests that the global economy must be studied first. The international economy might affect a firm’s export prospects, the price competition it faces from foreign competitors, or the profits it makes on investment abroad. Certainly, even though the fact that the economies of most countries are associated in a global macro economy, there is significant disparity in the economic performance across countries at any time.
In addition, the global environment proposes political risks of far greater magnitude than are typically encountered in U.S.-based investments. In the last decade, we have seen several instances where political developments had major impact on economic prospects. For example, in 1992 and 1993, the Mexican stock market responded dramatically to changing assessments when the U.S. Congress was seen expected to pass the North American Free Trade Agreement.
Of course, political developments can be positive, as well. For example, the end of apartheid in South Africa and the resultant end of the economic embargo portended great growth for that economy. These political developments (and the bumps along the way) offer momentous opportunities to create or lose money. Other political issues that are less sensational but still extremely important to economic growth and investment returns include issues of protectionism and trade policy, the free flow of capital, and the status of a nation’s workforce.
One obvious factor that affects the worldwide competitiveness of a country’s industries is the exchange rate between that country’s currency and other currencies. The exchange rate is that rate at which domestic currency is made to convert into foreign currency. As exchange rates fluctuate, the dollar value of goods priced in foreign currency similarly fluctuates, and hence impacts the inflation in different countries.
The macro economy is the setting in which all firms function. Therefore when the standing of the economy all together is to be assessed, assessing the broader market’s performance should start it. If an analyst can make efficient predictions about the macro economy, he or she can find fruitful investment avenues. However, just making good projections about the macro economy alone is not adequate. Such forecast should be superior than the one made by competitors in order to make abnormal profits.
Making an industry analysis is as significant as it is for macroeconomic analysis, and for the same reasons too. It is evident from the previous discussion that an industry can hardly function well in a poor macro economy. In exactly the same way, a firm can hardly function well in a distressed industry. Moreover, the execution and functioning of industries may differ in the same manner as it differs across different countries.
Hence, after making predictions about the macroeconomic state, it is the job of the analyst to establish the inferences of those predictions for the industries in particular. This has to be done specifically for each industry for the reason that different industries respond differently to the business cycle. Tobacco industry, for instance, is not quite reactive to the business cycle. The varying macroeconomic state castes no particular affects on the demand for tobacco products. Reason for this is the habitual consumption of tobacco that mostly makes a small part of budgets, which will not be sacrificed in times of difficulty. However auto production is exceedingly unpredictable. In times of depression, auto consumers may opt to prolong their use of the same cars in anticipation of an elevation in their income.
Three factors will establish the sensitivity of a firm’s income to the business cycle. First is the sensitivity of sales. Industries associated with necessities and those for which income is not a crucial determinant of demand, will prove diminutive sensitivity to business conditions. The second aspect shaping business cycle sensitivity is operating leverage, which refers to the division between fixed and variable costs. Firms with greater amounts of variable as opposed to fixed costs will be less responsive to business conditions. The level of operating leverage of a firm is directly associated with the level of its fixed costs. This is so because the profitability of such firms can be greatly affected by even smaller changes in the business conditions. Third aspect that shapes business cycle sensitivity is the level of borrowed funds for operations of business, which is the degree of financial leverage. No matter what the level of sales has been, the debt has to be serviced in shape of interest payments anyway. These payments tend to be those fixed costs that make the profits more sensitive to the business conditions.
Fundamental analysis represents the evaluation of the cash flows from an investment. Although each investment may have different characteristics, all can be valued using the discounted cash-flow approach that takes the present value of expected future cash flows. To do so, potential cash flows and the suitable discount rate must be estimated. For different asset types, different procedures are used to effectively estimate the future cash flows and discount rates.
In comparative analysis, some financial analysts work out common-sized (ratio) financial statements for a company under review and match them up with the industry total. The user can thus compare trends for the firm in relation to the larger industry group from which it is drawn. Rather than review complete financial statements for business firms, however, some fundamentalists merely refer to key financial data such as those provided on Trendline’s Current Market Perspectives charts.
Most stock fundamentalists attempt to determine by using one or several quantitative models, an underlying or intrinsic value for a common share, comparing this “value” to the price of the stock to gauge its under pricing or overpricing in the market. The most popular of these models are the dividend growth model, the price-earning model, the cash flow per share model, and the Benjamin Graham intrinsic value model.
Technical analysis is all about considering historical movements in the prices of stock of a firm instead of placing importance on the fundamentals, which establish the future earning prospects. Technical analysts believe that the past statistics and data on prices and volumes are indicators of the upcoming price changes. “Technical analysis is in most instances an attempt to exploit recurring and predictable patterns in stock prices to generate abnormal trading profits. In the words of one of its leading practitioners, ‘The technical approach to investment is essentially a reflection of the idea that the stock market moves in trends, which are determined by the changing attitudes of investors to a variety of economic, monetary, political, and psychological forces. The art of technical analysis, for it is an art, is to identify changes in such trends at an early stage and to maintain an investment posture until a reversal of that trend is indicated.’”
Pure stock technicians often disregard the fundamental strengths and weaknesses of an individual stock (or the market as a whole), while attempting to gauge the demand and supply for the issue(s). The technicians study price movements, relative strength, volume of trading, price trends, and certain key patterns that often indicate strength or weakness, support and resistance level, and estimated moves. Technicians attempt to interpret chart action, usually in the form of vertical bar or point and figure charts, although a few chart services are constructed with simple or weighted average line charts for price and/or volume of trading. Technicians hold the view that the popular stock averages are one of the early leading indicators, and that certain groups of stock lead these averages. Their efforts, then, are attempts to gauge these early movers (upside or downside) long before the market average or economy (viewed by the economists and fundamentalists) makes it turn. Thus the technicians attempt to take early positions in equities before fundamentalists suggest such justification and to exit them before they take a nosedive.
Technical analysis has positive value and allows traders to make better investment decisions. They are able to better interpret new information if they make use of information revealed in past prices. Furthermore, technical analysis gives them a better idea about the exact and proper worth of the underlying asset. Learning from past prices alters their trading strategy and thus also affects the price process.
Past prices always provide information in a setting with asymmetric information. The crucial question, however, is whether the information inferred from past prices is useful. Only then would technical analysis have positive value. Technical analysis is useful if it
1) Improves the traders’ portfolio choice, and
2) Adds to the information already revealed by the current price.
In a setting where traders can trade conditional on the current price, the current price might already reveal all relevant information. This is the case for (strong-form) informationally efficient equilibria where the current price reveals an adequate gauge for all private information in the economy. In that case there is no need to incorporate past prices in current trading decisions.
There has been bias that technical analysis provides no useful information as long as the market is weak form informationally efficient. Technical analysis was therefore considered to be irrational. The reasoning was that if there were a possibility to profitably exploit information inferred from past prices, other traders would have already exploited it. However, this simple argument overlooks the fact that different traders may value the same income stream differently. Their evaluation depends on their marginal rate of substitution at a certain allocation. Traders might also differ in their degree of risk aversion, endowment, and so on. Consequently, they typically do not face the identical portfolio selection problem. A certain risky dividend stream might be attractive to one trader, yet it might not be considered as profitable by other traders, given their risk aversion and endowment. In a more general setting, past prices carry useful information for deriving the optimal stock holding and the future price path.
However, the simple original argument holds in economies with competitive risk neutral traders. Risk neutral traders would have already exploited any expected profit opportunity based on information inferred from past prices. Therefore, these opportunities cannot arise in equilibrium and thus technical analysis has no value. Another special example in which technical analysis has no value involves a setting in which there is a group of competitive risk neutral traders who observe the public limit order book. In this case, no risk premium is paid and the price is driven by the information of this competitive fringe, which already incorporates information reflected by past prices.
The main focus of technical analysis is to get a better prediction of the underlying value of the stock. Technical analysis is, however, also valuable for evaluating new information. Quite often when one receives new information, one does not know whether it is already reflected in the price or not. Looking at past price movements might help answer this question.
Even if a trader knows that a piece of his newly acquired information is already partially reflected in the current price, he would still like to know the extent to which it already moved the price. This is also true in the case of a public announcement. The newly informed public would like to know the extent to which the information is already reflected in the price. Brunnermeier (1998) illustrates how the public looks at past price movements to improve their knowledge. This model makes clear that the argument presented earlier only holds as long as the past price still carries information even after the public announcement. The information content of past prices has to be about the true value of the asset and/or about the execution price. The latter is only of use for traders who can only submit market orders. The author employs a strategic market order model similar to Kyle (1985).
The focus of Brunnermeier (1998) is on the characterization of the trading strategy of insiders who receive an imprecise signal prior to the public announcement. The analysis shows that the early-informed insider tries to manipulate the price prior to the public announcement in order to tamper with the other traders’ technical analysis after the public announcement. This activity is often characterized as signal jamming. In addition, the insider’s trading strategy exhibits a speculative feature. He buys on (positive) rumors and sells on news.
The discussion thus far indicates that technical analysis to evaluate new information helps us avoid the possibility of considering the same information twice. Therefore, it helps us get a better estimate of the proper underlying value of the asset. Hence, this form of technical analysis is just an indirect way of gathering more information about the fundamental value of the stock. Inferring information about the value of the stock remains the eventual purpose of technical analysis.
Technical analysis is classified into three categories: trend-following systems, systems that analyze valuation ranges, and systems that estimate changes in required returns. Although some technical analysts may focus on only one particular system or type of system, many technical analysts evaluate more than one trading system. Empirical evidence indicates that some technical trading systems (or combinations thereof) can be effective in earning abnormal profits. Although some technical analysts use complex computerized systems, many good technical analysts rely solely on simple systems and judgment.
Some stock fundamentalists place importance on reviewing a series of balance sheets and income statements for a given company (trend analysis) to detect changing trends in sales, profit margins, financial safety, or an appropriate mix of debt and equity. Meanwhile, some analysts go so far as to compare percentage (common-sized) financial statements for several firms in the same industry or to use published benchmark ratios.
The successful evaluation of common stocks requires the use of more than one tool or philosophy. Today, the globalization of markets and greater than before unpredictability in intraday prices has all created complexity in analyzing investments. It is no longer advisable to employ merely a technical approach without taking the macroeconomic and fundamental aspects into account. Thus I conclude that neither technical nor fundamental factors should be used exclusively when making a decision on individual common stock investments. The best method for obtaining thorough knowledge of a stock appears to be with a combination of fundamental and technical considerations.
Austin Murphy (2000): “Scientific Investment Analysis.” Quorum Books. Westport, CT.
Behavioral Finance And Technical Analysis http://highered.mcgraw-hill.com/sites/dl/free/0072510773/71083/bodie_sample_ch19.pdf Accessed December 3, 2006.
Brunnermeier, Markus K. (1998): “Buy on Rumors – Sell on News: A Manipulative Trading Strategy.” Mimeo, London School of Economics.
Carroll D. Aby Jr.& Donald E. Vaughn (1995): “Asset Allocation Techniques and Financial Market Timing.” Quorum Books. Westport, CT.
Fundamental Analysis http://stockcharts.com/education/Overview/fundAnalysis1.html Accessed December 3, 2006.
Fundamental Analysis versus Technical Analysis http://daytrading.about.com/cs/charts/a/anylisis.htm Accessed December 3, 2006.
Kyle, Albert S. (1985): “Continuous Auctions and Insider Trading, ” Econometrica, 53, 1315-1335.
Louis B. Mendelsohn “Technical analysis has become the primary basis for making trading decisions” http://www.tradertech.com/technical_fundamental.asp Accessed December 3, 2006.
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