Understanding the 3 Methods Used in Stock Investment Analysis
Everyone knows the key to successful stock investing is to buy low and sell high. To determine when a security is priced too low (i.e. undervalued) and when it’s priced too high (i.e. overvalued,) investors use different types of analysis, the three main ones being:
Each of these strategies for assessing the value of an asset has its own advantages and limitations; no single method is complete in itself. Depending on the type of trading or investing you are doing, one or more of these strategies may be the most appropriate to better help you manage risk.
1. Fundamental Analysis
Fundamental analysts aim to determine the intrinsic value of a security, or its objective value based on conditions of the business, the market and the economy. Intrinsic value is considered to be fair market value for that security, meaning that if a buyer and seller were to exchange money for that security, neither one would have an advantage in the transaction. Of course, such a transaction never occurs, which is how and why this strategy works. Once you know the intrinsic value of a security, you can determine whether the current market price for that security is expensive, cheap or priced just right.
Fundamental analysis is based on the belief that a security's price does not fully represent all known financial data about or affecting that company and its stock price. The objective of fundamental analysts, then, is to identify those gaps between a security's price and its intrinsic value and invest accordingly. Put another way, the goal is to figure out if a company's current stock price accurately reflects its future value.
To predict a security's short-term and long-term future value, fundamental analysts consider a variety of factors both micro-economic and macro-economic, including:
The state of the overall economy
The condition of the given business sector and industry
The financial health of the business issuing the security
If fundamental analysis reveals that the security most likely fully reflects the company’s value, the security may be deemed a Sell; if, by contrast, it reveals that the market most likely underestimates a company’s future outlook, the security at its current price seems attractive, making it a potential Buy. In either case, the security may be a Hold depending on the price movement the investor predicts for it.
Tools of Fundamental Analysis
Fundamental analysts evaluate an investment’s value using publicly available financial data recorded on various financial statements like annual and quarterly filings and reports such as the annual 10-K or quarterly 10-Q. Another informative report, the 8-K, is filed anytime a company undergoes a reportable event, such as a change in upper-level management or a merger or acquisition.
Common tools traders use to conduct fundamental analysis include:
Financial reports and financial ratios generated from them
Graphs, charts, spreadsheets and infographics
Government agency reports on the economy and various industries
Fundamental analysts may also speak with a business’s management team and participate in regular investor calls to better evaluate how the marketplace is receiving its products or services.
Quantitative and Qualitative Analysis
While there are seemingly countless factors fundamental analysts can consider, they all fall into one of two categories: quantitative and qualitative factors. Neither qualitative nor quantitative analysis is superior to the other; rather, they complement each other for a more thorough and comprehensive fundamental analysis.
Quantitative factors involve statistical fundamental data you can measure using numbers, formulas, figures and ratios. These include such company financial data as revenues and earnings, profit margins and return on equity.
Much of the data used in quantitative analysis is gleaned from the three main financial reports that all publicly-traded companies must release regularly: balance sheet, income statement and cash flow statement.
Balance Sheet – This statement provides a snapshot of a business’s equity, assets and liabilities. It gets its name from the fact that all three sections should balance based on the formula: Shareholder equity + company liabilities = company assets.
Assets are considered any and all resources the company possesses or controls, including:
Liabilities and equity are what finance those assets. Liabilities may include debt and other obligations, while equity represents the total financial contribution of the owners including retained earnings, or the profits left after all applicable deductions (eg. dividends, taxes) are subtracted.
Income Statement – Whereas a balance sheet provides a financial snapshot of a moment in time, the income statement looks at a company’s financial performance over a set period of time; this could be a day, week or month, quarterly or annually, to name some of the more common periods. Publicly traded companies must report income quarterly and annually.
The main information an income statement provides for any given period are the company’s:
Cash Flow Statement – Also called a statement of cash flows, this document shows a company’s cash inflows and outflows for any given period. Generally, a company’s cash flow statement will focus on the following activities:
Operating cash flow (OCF) – Cash received from daily business operations
Cash from financing (CFF) – Cash paid from issuing funds and cash received from borrowing funds
Cash from investing (CFI) – Cash the company uses to invest in assets and its proceeds from the sale of long-term assets, buildings and equipment
While the income statement and balance sheet may include obligations not yet paid and receivables not yet received, the cash flow statement measures only cash on hand.
Qualitative factors are more intangible and descriptive and involve assessments of the state, condition or nature of things. These may include quality evaluations of brand-name recognition, top executives, proprietary technology or patents.
Key qualitative factors to consider include the following:
Industry – In order to evaluate a company’s performance, you need to put it in the larger context of the health of its overall industry. These include matters of prospective growth, customer base, business cycles, regulation, competition and market share. This helps you figure out which company, if any, in a given industry to invest in or whether to invest in that industry at all.
Business Model – What does a company do? How do they make money? How do they operate? And, how well is that working for them? Is there a more efficient and potentially profitable way they could (or should) be operating?
Corporate Governance – What are the company’s policies regarding the responsibilities and relationships between directors, management and stakeholders. To find this out, take a look at the company’s bylaws, the company charter and their corporate regulations and laws. The companies you want to invest in are those that are run fairly, ethically, efficiently and transparently. Make sure a company’s management respects shareholder interests and rights and that their shareholder communications are clear, understandable and transparent before investing in them.
Management – A business is only as effective as the team running it. Even the best business model and corporate governance can amount to nothing if it doesn’t have the proper team executing it. The quality of the executives in a company is a strong indicator of its own quality and potential. Read up on a company’s key executives before investing in them. What is their prior experience, and how well did they perform in those roles? What are their professional achievements? Have they been accumulating or dumping company shares of late?
Competitive Advantage – What makes a particular company more appealing to customers than other companies offering the same or similar products or services? What is the company’s unique selling proposition (USP,) and is that enough to sustain growth? A company with a strong competitive advantage in its field creates a “moat” around itself that protects its market share from competitors.
2. Technical Analysis
Technical analysis aims to determine the future direction of a security's price by evaluating the security's recent movements and trading trends. Technical analysts study trading activity to make statistical analyses of price movement in a security. Their primary methods of doing this are searching for patterns and trends.
This strategy is grounded in a belief in market efficiency, or that a security's current price has already discounted, or taken into account, every known factor, fundamental and sentimental alike; this renders these measures irrelevant and allows stock price movement to be the sole determinant of future projections. Technical analysts consider this movement as the simple result of the supply and demand in the market for a given security.
Technical analysts also operate under the assumption that even price movements that may seem random actually move in discernable patterns that, over time, tend to repeat.
Tools of Technical Analysis
The primary tool of technical analysts for identifying these patterns and trends and predicting their future movement is stock charts. On these charts, technical analysts can track the movement of a security over a set period of time. Among the main factors reflected in these charts are a security's direction, volume and velocity or momentum. Technical analysts may examine various metrics to help signal changes in these measures, such as whether a security's price will continue on its current trajectory or reverse.
If a security's price has been moving consistently higher or lower, a technical analyst might study upward and downward trendlines to extrapolate potential movements; if a security's price has been range bound (ie. staying within a limited price range, neither trending much higher or lower than a general mean,) the analyst might search for support and resistance levels.
In securities trading, the term support refers to a price point at which the security seems attractive to buyers who will come in to purchase the security and, thereby, prevent it from falling below that level; the term resistance refers to the opposite: a price point at which the market finds the security fully valued, prompting sellers to unload the security and, thereby, keep it from going any higher.
Support levels therefore provide upward pressure to a downwardly trending security's price, while resistance levels provide downward pressure to an upwardly trending stock price.
Other common metrics used in technical analysis include:
Chart patterns – By connecting certain sets of prices for a security, chartists, or technical traders, can create a pictorial pattern or arrangement that can help them determine where the price for that security may go next.
Price trends – Trendlines help identify a consistent upward or downward trajectory in price movement; channels, then, help to determine how far above and below that trendline a particular security's price may range at any point in time.
Moving averages – These are lines that smooth out the erratic short-term swings in a security's price to determine its general, trending movement over a set period of time. The longer the period, however, the more of that “noise” is removed from the chart, making it easier to see a general trend, but harder to pinpoint swings away from that trend with any precision.
Momentum and volume indicators - These types of metrics help traders to determine how strong or weak a security currently is in order to evaluate how stable and reliable its current price point may be. Volume indicators measure how many units of a particular asset are bought or sold in a given time frame; momentum indicators measure how fast or slow its price rises or falls in a set time. The moving average convergence divergence (MACD) and the relative strength index (RSI) are two commonly used momentum indicators.
Oscillators – This type of indicator helps traders identify whether a security is overbought or oversold in the short term. They are made of a trend line that fluctuates between a high and low band constructed between two extremes in price value. As the oscillator’s value approaches the higher extreme, the security is considered overbought; as it approaches the lower extreme, the security is considered oversold. Traders will often enter one or more oscillators into a stock screener to help identify which securities are primed for buying or selling.
Technical analysts will often use a process called backtesting to check their current strategies against historical data. It allows traders to gauge how well a current strategy may have worked in the past without putting any actual capital at risk. Since technical analysts operate under the assumption that history repeats itself in the market, they're likely to conclude that a strategy that doesn't pass muster in backtesting is unlikely to work moving forward with any confidence. Common measures technical analysts use for backtesting include:
Also referred to as sentimental analysis, sentiment analysis examines prevailing crowd psychology to determine the tone or feeling of the market. Not to be confused with semantic analysis, which is a language tool used to draw semantic meaning from texts, sentiment analysis is a tool that stock market analysts use to assess investor attitudes or “take the temperature of,” the market. They, then, invest in opposition to this determined sentiment and how the rest of the market is, therefore, investing giving to their popular name of contrarians.
For instance, if the general market sentiment is that a security's price is likely to go down, sentiment analysts might opt to buy that security; if the market expects a trend to reverse, sentiment analysts might decide the trend is likely to continue. They view pessimism in the market as a buying opportunity and optimism in the market as a trigger to sell.
Sentiment analysis is based on the precept that most investors are incorrect in their assessment of the prevailing market environment, meaning when too many analysts think a security's price is going in a certain direction, the security is likely to prove otherwise.
You can build an entire investment strategy around sentiment analysis alone, but it requires patience and a potentially longer time horizon to work. Basing your investing decisions on the news depends on there actually being actionable headlines on any given day.
You can compensate for the biases in sentiment analysis by incorporating one of the other two strategies: technical analysis over the short-term and fundamental analysis over the long-term.
Tools of Sentiment Analysis
There are a variety of indicators investors use to measure the current market sentiment. Among those most commonly used are the following:
The CBOE Volatility Index (VIX) – Commonly known as the “fear index,” the VIX is a measurement of volatility in the marketplace. In market terms, volatility represents how far from a mean or median price a security's price moves over a set period of time. If a security's price doesn’t stray far from that level, it is considered to have low volatility; if it makes wild swings far above and below that level, however, it is considered a high-volatility security. Securities with low volatility tend to have lower risk of loss but also lower profit potential (at least in the short-term,) while securities with high volatility tend to have higher risk of loss but also higher profit potential (again, in the short-term.)
The VIX is a factor of options prices, determined by how much protection options traders are purchasing as insurance against their trades, or “hedging” their trades. Greater hedging implies less confidence in the projected price movement of a security and, therefore, increases volatility; less hedging implies greater confidence and, therefore, reduces volatility.
High-Low Index – This index represents the ratio of how many securities are currently hitting their respective 52-week highs vs. how many are hitting their 52-week lows. Traders apply this formula to indices like the New York Stock Exchange (NYSE) Composite, NASDAQ 100 and S&P 500 to estimate where a security's current price sits in relation to its performance and that of other similar securities over the past year.
This indicator is a type of oscillator, which means investors can use it to evaluate short-term conditions. When this ratio falls below 30, securities are said to be trading near their lows and, therefore, are potentially oversold, suggesting the security may be a bargain for buyers; when it rises above 70, securities are said to be trading near their highs and, therefore, are potentially overbought, suggesting selling the security may be in order before its price falls.
Moving Averages – Investors often track more than one moving average and compare them against one another to get a better gauge of price movement and identify ideal entry points into desired investments. A common pair to track and compare are the 50-day and 200-day moving averages. When the 50-day moving average of a security's price falls below its 200-day moving average, this is considered a bearish signal that the security's price is experiencing selling pressure and is likely to continue dropping; when it crosses above its 200-day moving average, it’s considered a bullish signal that the security's price has garnered some momentum among buyers and is likely to continue rising. This concept is based on the premise that a security is more likely to continue moving in its current direction than it is to suddenly switch directions without some significant impetus, like a major corporate or economic event.
Sentiment analysts will also keep close tabs on the news, including current headlines and events involving the global or national economy or a particular industry, company or executive.
Which Trading Strategy to Use
Always instrumental to any investing strategy is remembering that past performance won’t guarantee future outcomes and actual outcomes will vary. Stock prices fluctuate as market conditions change, and shares you own could be worth more or less than you paid for them when you unload them.
Which form of stock investment analysis you use depends on many factors, not the least of which are your own personal preferences. Whichever you choose, however, the key to making it work is to build a portfolio that matches your goals, risk tolerance and time horizon.
Important: The information provided in this blog is for educational and informational purposes only and should not be construed as investment advice. The author is not a registered investment advisor and does not provide personalized financial or investment advice. All investments involve risk, and past performance is no guarantee of future results. It is recommended to consult with a professional financial advisor before making any investment decisions. The author and publisher shall not be held liable for any losses incurred as a result of the use of the information presented in this blog.
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