WHAT’S TRENDING: Analyzing Stock Investments for Beginners
For many, investing in stocks means risking your money into the unknown. Mind you though, investing in stocks is not a totally random walk. There are ways of analyzing stocks so that you can invest in them in a more calculated way. These methods are commonly categorized into two: fundamental analysis and technical analysis.
FUNDAMENTAL ANALYSIS
Fundamental analysis is a method of evaluating a company and determining a stock’s intrinsic value aka its “worth”, by creating a model based on publicly available data. This intrinsic value of a business is the “true” value or share price of a stock based on its worth as a business, its potential for future growth, and the overall condition of the industry and economy. In a more technical way, this intrinsic value is the present value of the business’ future earnings. You must carefully note that a stock’s intrinsic value is different from its market value which is the current price at which you can buy or sell a stock in the market.
One of the two primary assumptions in fundamental analysis is that the current market price does not fully reflect the “true” value of a company. While the intrinsic value only considers business fundamentals or business performance, the market price of a stock factors in market sentiments, aka feelings and emotions of investors, which has little to no effect on how a business performs in the long run. The second assumption is that the value of a stock reflected in indicators or fundamental factors are the closest approximation of its true value. As such, by comparing this intrinsic value with the market price of a stock, fundamentalists can know whether a stock is valued correctly or not and make investment decisions from this. Sounds intimidating, right? Don’t worry, we’ll break it down for you in the following paragraphs.
Indicators
The first thing to do in fundamentals is to look for indicators. Indicators are fundamental factors that can affect the value of a company over time which is why it must be greatly considered in estimating the intrinsic value. These factors can be categorized in four ways: macroeconomic and microeconomic factors, and quantitative and qualitative fundamentals.
First, let’s discuss macroeconomic and microeconomic factors. Macroeconomic factors deal with economy-wide and industry-wide data. These include forecasted industry growth, interest rates, and inflation. On the other hand, microeconomic factors deal with business-specific data like its products, management, brand value, competitive advantage, dividends, and technology. As the prefixes suggest, macroeconomic factors deal with “the bigger picture” while microeconomic factors deal with the specifics of the company itself.
Next, we have quantitative and qualitative fundamentals. From its name, quantitative fundamentals are measurable factors represented by numbers. The richest source of these are a company’s financial statements. Other examples of quantitative fundamentals are inflation rate and interest rates. On the other hand, qualitative fundamentals are those which describe the nature or standard of something. These include a company’s business model, new products, management, and economic moats. An economic moat is the durable competitive advantage that protects a business from unpredictable events. An example of this is the cost advantage where the pricing of a company’s products is lower than that of its competitors. To put it simply, an economic moat is the answer to the question: “What advantage does this company have that separates it from its competitors?” Usually, qualitative fundamentals make fundamental analysis difficult to do since, as the name suggests, they are hard to quantify and in turn, make it tricky to input in valuation models. As such, analysts need to make assumptions on these factors which, in most cases, are subjective. Therefore, one of the reasons why it is challenging to accurately estimate a stock’s intrinsic value.
Valuation
So now, the question is how do we get a stock’s intrinsic value? To compute for this, we do a valuation. Valuation is the process by which we create models and input specific indicators to the model in order to derive a stock’s intrinsic value. Think of valuation as a recipe where you follow a procedure (by creating models) and add ingredients, or in this case, indicators. In the end, instead of a cake, your finished product is something even more satisfying — the “true” value of a stock. There are two commonly used ways to go about this “recipe”: absolute and relative valuation.
In absolute valuation, the value of a business is derived only from the fundamental characteristics of the business like its cash flows, growth, and risk. The most common absolute valuation method is the Discounted Cash Flow (DCF) method where a business’ projected earnings are determined and discounted using a discount rate to reflect the time value of money. The challenging part of this method is that it requires a lot of assumptions and projections, which are difficult to accurately estimate.
On the other hand, relative valuation relies on a benchmark as a basis to know what other people are paying for assets just like it. This benchmark can be a whole industry or a comparable company with similar cash flows and growth. Benchmarking usually takes the form of comparing ratios. In the Philippines, the most common one is the price-to-earnings (P/E) ratio. Other examples are the price-to-sales, price-to-book value, and price-to-cash flow ratios. Another way to benchmark is through precedent transaction analysis where you determine a business’ value based on other businesses in the same industry that has recently been sold or acquired. With this, relative valuation is used more frequently than absolute valuation because it is easier to derive the intrinsic value using this method.
Comparing Intrinsic Value with Market Price
After we get the intrinsic value, we compare it to the market price. This step is important to know if the market value is equal, greater than or less than the intrinsic value of a stock.
The basic rule is that the market price of a stock will approach its intrinsic value over time. As such, if the market price is greater than the intrinsic value, the stock is overvalued. This means that the stock is currently being bought and sold at a price higher than its true value. In the long run, there is a high probability that the market price of an overvalued stock will go down to its intrinsic value. On the other hand, if the intrinsic value is greater than the market price, the stock is undervalued and we expect that in the long run, there is a high probability that the market price of the stock will increase to its intrinsic value. In other words, the stock is currently being bought and sold at a price lower than its true value. Meaning, it would be a good idea to buy it now because in the future, you expect it to increase to its true value.
Fundamental analysis is very useful in value investing wherein people invest in undervalued stocks. To further illustrate the previous paragraph, let’s look at the price of a well-known stock here in the Philippines. Let’s say the market price of JFC is ₱150 but upon conducting fundamental analysis, you found out that its intrinsic value is actually ₱200. In this situation where the stock’s intrinsic value is greater than its current price, we say that the stock is undervalued. Now, what would fundamentalists suggest? Investors should buy this stock since they expect that if they invest now, their ₱150 may grow to ₱200 in the future. This gives them a possible profit of P50. A piece of cake, right?
TECHNICAL ANALYSIS
Technical analysis aims to evaluate investments and identify trading opportunities. This method makes use of past market data to forecast the direction of prices. The most common data that technical analysts (or technicians) study are the price of stocks and volume of traded stocks.
What differs between fundamental and technical analysis? Well, in fundamental analysis, recall that we value a business based on business fundamentals and future earnings. However, for technical analysis, historical data derived from stock price and volume of traded stocks take priority. The reasoning behind this is technicians believe that the known fundamentals are already reflected in the stock price. An easier way to know the difference between the two is remembering that fundamental analysts look to the future while technical analysts look back on the past.
Price
For technicians, price reflects all relevant information in the market. They believe that all other information (what fundamentalists would spend the most time researching) are already reflected in the market price. This includes market expectations of what is likely to happen. A certain stock’s price is determined by the rules of supply and demand. In the stock market, supply comes from those who want to sell stocks while demand comes from those who want to buy stocks. When we look at the law of supply and demand, when supply increases or demand decreases, we expect stock prices to go down, and vice-versa. The supply and demand here is mainly affected by market sentiments, expectations, emotions and psychology.
Imagine a share as a seat in a cinema where people can’t go out of the cinema without having a replacement for his/her seat. When people are optimistic about a show, many people will want a seat. But since there are only a limited number of seats and there are many buyers, many will be willing to pay a higher price just to get a seat. However, if the cinema is covered with dark, suffocating smoke, those who currently have a seat will want to sell it but there are not many people who will want to buy it given the smoke in the cinema. As such, those who have a seat will be willing to sell theirs for a lower price to attract more people to buy their seats.
Given this analogy, if there is news about a company that indicates a significant drop in its earnings, what’s likely to happen is that many will sell their shares of that company. This is because a significant drop in a company’s earnings entails a drop in the earnings per share. When a lot of investors sell their shares, this increases the supply of the stock available, this then leads to a price decrease. Sometimes, this information will not immediately be factored into the stock price — contrary to the efficient market hypothesis which states that the market is efficient since price immediately reflects all available information at any point in time. Investors will not immediately flood the market to sell their stocks since it will take a bit of time for them to absorb the news. This is an example of a market anomaly that can be discovered by analyzing charts and trading volumes. This is a good opportunity for technicians to sell a stock before the price absorbs all this information.
Charts
Charts are where the stock prices across a period are plotted. This is being used to identify patterns and trends which are used as a basis for buy, sell, or hold decisions. However, as a technician, charts are not your only source of information. Though less utilized than charts, other methods, like surveys and interviews, offer more comprehensive views of market sentiments and psychology which are of equal importance in technical analysis.
The most used chart in technical analysis is the candlestick chart. The candlestick chart in the image above is that of the Philippines Stock Exchange Index (PSEi) as of September 9, 2020. In the chart, time is measured along the x-axis while stock price is reflected along the y-axis . The candlestick chart is called such because stocks prices in a day are described using bars and sticks that resemble a candle.
The candlestick is formed by a wick and body and is analyzed based on its four components: (1) high, which is the highest price reached by a stock in a trading day; (2) low, indicating the lowest price reached by a stock in a trading day; (3) open, or the price of a stock on the start of the trading day; and (4) close, or the price of a stock at the end of the trading day.
The two main types of candlestick are the bearish and bullish candles. The bearish candle, usually red, occurs when the close is lower than the open which means that from the beginning to the end of the trading day, the stock price decreased. On the other hand, a bullish candle, usually green, happens when the close is higher than the open which means that the trading day closed at a higher price than when it began. To better remember this, just know the way a bear and bull attacks — a bear attacks by swiping down to its enemy while a bull thrusts its horns up in the air.
Principles in Technical Analysis
There are three main principles in technical analysis:
- Market action discounts everything. Since price already reflects all relevant information, it is important to know what investors know and how they perceive it since this will back their actions. Recall that prices move because of supply demand, caused by the actions of investors.
- Price moves in trends. These trends are directional: up, down or sideways.
- History tends to repeat itself. Technical analysts believe that investors repeat the behavior of the investors that precede them. Because investors repeat behavior, technicians believe recognizable and predictable price patterns will develop on charts because charts mirror investor behavior.
Advantages & Disadvantages
To recap, fundamental analysis is useful in passive or long-term investing. Recall that the goal of a fundamental analyst is to calculate the intrinsic value of a stock. This is the value that that market price will most likely approach in the long run. Also, the in-depth and extensive research and analysis required to conduct fundamental analysis allows one to develop a thorough knowledge of a business and industry. However, this requires a data set that is not readily available to small investors. It also says little of short-term price movements and market timing. Lastly, there are a lot of assumptions to be used in fundamental analysis. The consequence of this is that it is usually subjective, hard to estimate, and seldom accurate. A small change in any of the fundamental factors can greatly affect the estimated intrinsic value of a stock.
On the other hand, the advantage of technical analysis is its usefulness for short-term trading as well as timing market entry and exits. It is also less time-consuming than fundamental analysis. However, charts may bring confusion since it can be used to show a lot of indicators which, in most cases, give mixed signals with one indicating a buy while the other indicating a sell. In addition, insights from stock prices gained through technical analysis is less useful in the long run since information reflected in the price becomes less relevant the older it gets.
So which is better: fundamental analysis or technical analysis? For many, there is no best choice. Many investors use both. For example, they use fundamental analysis to pick stocks and technical analysis to time when they will buy or sell it. However, at the end of the day, the decision is entirely up to you. Just remember to set SMART investment goals that match your risk preference and not to put all your eggs in one basket.
As an investor, you don’t just accumulate information about companies and economies. The key is processing this information — through fundamental and technical analysis — to take advantage of opportunities in the market. Whether you are a technician, fundamentalist, or something in the middle, I’m sure that your newfound knowledge of analyzing stocks can give you a new perspective of businesses, the market, and the investing public.
If after reading this article and you still feel like stocks are too risky for you or you just want to add a safer asset to balance out your portfolio risk, then maybe you need to watch out for our next article as we introduce you to the basics of bond investing.
More articles on finance? Check out UP JFA’s Pisopedia page. That’s all for now. Happy investing!
