Comparing Fundamental and Technical Analysis
The Differences Between Technical and Fundamental Analysis
Fundamental and technical analysis are two major ways to analyze a stock. Fundamental analysis compares a stock's intrinsic or fair value to its share price to find companies that may be over- or undervalued. Technical analysis studies a stock's past price movement to spot trends indicating where its price will move. A well-rounded stock analysis will blend both methods to form a comprehensive view of a stock.
What Is Fundamental Analysis?
As the name implies, fundamental analysis is a method of computing a company's business “fundamentals” to arrive at its intrinsic value, taking macroeconomic factors into account. Fundamental analysis assumes that a company’s share price will trend toward its intrinsic value over time despite its current value. Fundamental analysis is better suited to finding a company's long-term value than technical analysis, making it more suitable for investment than trading decisions.
Tools Used in Fundamental Analysis
Fundamental analysis is more research-intensive than technical analysis. It uses fundamental business metrics to calculate a company’s intrinsic value and compare it to its share price and comparable companies.
Some of the tools used in fundamental analysis include:
- P/E Ratio: the current share price/earnings per share;
- P/S Ratio: the current share price/revenue per share;
- Earnings per share and;
- Dividend yield.
Another value metric used in fundamental analysis is Enterprise Value, which expresses a company’s total value as its market cap + long- and short-term debt, less cash and cash equivalents. Enterprise value is considered a more comprehensive expression of a company’s value than market cap alone.
Advantages and Disadvantages of Fundamental Analysis
Advantages
- Based on hard data;
- Focused on identifying stocks with a strong growth potential;
- Includes macroeconomic data such as inflation and interest rates;
- A comprehensive view of the company provides better risk mitigation;
- Can indicate whether a stock is under- or over-valued based on intrinsic value.
Disadvantages
- Geared more for investing than trading;
- Far more labor-intensive than technical analysis;
- Requires knowledge of micro- and macroeconomics.
- No way to tell how long it will take for a trade to pay off;
- External inputs such as economic and political events can upend long-term price assumptions;
What Is Technical Analysis?
Technical analysis focuses on a stock's past performance to identify trends and patterns that may predict its short-term price movement. It ignores a company’s fundamental value in favor of measuring and predicting the price and volume of its shares. Technical analysis is a forward-looking valuation method, making it more suitable for analyzing growth stocks than value stocks. It is used more for short-term and intermediate trading than investment.
Tools Used in Technical Analysis
Technical analysis depends on several types of charts and data to determine the entry and exit points of a trade. These charting tools allow a trader to visualize data and easily spot trends. Popular types of charts are line charts and candlestick charts. Candlestick charts convey far more information than line charts, showing the entry, high, low, and exit price points for each time segment.
Some of the tools used in technical analysis include
- Simple and Exponential moving averages;
- Moving Average Convergence Divergence (MACD);
- Stochastic Oscillators;
- Bollinger Bands, and;
- Relative Strength Index.
Advantages and Disadvantages of Technical Analysis
Advantages
- Uses time-tested market indicators and patterns;
- Objective analysis of charts and indicators can reduce emotional trading;
- Can give early indication of possible trend reversals;
- Gives insight into trader sentiment by tracking supply and demand, and;
- Is customizable for use in different trading strategies;
Disadvantages
- Ignores the underlying valuation of the company being traded;
- Subject to personal bias;
- Susceptible to losses caused by sudden changes in short-term sentiment;
- Indicators can signal a reversal too late to take advantage of.
- Overreliance on past performance (which is not indicative of future results;