What is Fundamental Analysis?

It is the process of looking at a company’s business from an investment point of view. The process involves analysing a company’s management capabilities, its competitive advantages, its competitors and the markets it functions in. As part of the analysis, you would look at examining key financial ratios like the net profit margins, operating margins, earnings per share and so on. After examining the key ratios of a business, one can come at a conclusion about the financial health of a stock and determine the value of the stock. It further focuses primarily on the valuation of a company and its relationship with the current share price. Combining all this, the analyst arrives at a valuation for a stock. Fundamental analysts believe that it is possible to estimate the true value of a company using these financial valuation methodologies. If the share price is trading below the value arrived at by a fundamental analyst, investors should buy the stock, in anticipation of the share price rising to the true value in the future. Conversely, if the share price is higher than the estimated true value, investors should sell.

What is Technical Analysis?

This technique focuses on the past to predict the value of the future, using share prices and volumes traded in a stock. It does not look at fundamentals or financial results at all. Technical analysts believe that all information about a company is factored into the share price. According to them, share price behaviour is repetitive in nature and hence can be used to predict future share price movements. Based on historical share price data of a company, technical analysts identify share price levels that act as support or resistance. They try to identify support, resistance and breakout levels for stocks. Technical analysts also use various technical indicators and chart patterns to help them determine probable future share price movements.

What is quantitative analysis?

With the advent of computers, a third type, namely quantitative analysis, has come up. Quantitative analysis seeks to understand behaviour by using complex mathematical and statistical modelling, measurement and research. It is a process of determining the value of a security by examining its numerical, measurable characteristics like sales, earnings and profit margins. Pure quantitative analysts look only at numbers with almost no regard for the underlying business. Although even fundamental analysis look at numbers from a balance sheet, their primary focus is always the underlying business, the environment in which the company is operating and so on. Quantitative analysts create mathematical algorithms, which help them arrive at buy and sell decisions.

Which is the best?

The different analytical tools have different uses. For instance, fundamental analysis could be used to identify companies with a possibility of strong earnings growth in the future. Technical analysis could be used to decide when to buy this stock. When you combine technical and fundamental analysis it is called techno-fundamental research. Depending upon your style and time frame of investment you could choose among them.

There are many factors affecting the collective mood of the stock market. Stock Market is a dynamic one which changes with every information due to change in perception of the investors. Stock Market believes in supremacy of the market and considers that demand-supply mechanism leads to efficient price discovery. It also considers that the market discounts/considers everything and presumes every investor to be rational who invest by considering all the informations (economic and political (domestic and international) scenario, weather condition, company
specific news, international relations, monetary and fiscal policies, international Stock Market behavior and many more) available to him.
Stock Market Analysis is a prerequisite for any investor for extracting profit out of the sock market. But most of the investors don’t have the time and knowledge for analyzing the market. So, they take the help of professional Stock Market Analysts who guide them through the financial
jungle to a profitable outcome.

Stock Market Analysis is basically of two types :-
• Fundamental Analysis
• Technical Analysis

Often you will find the EPS forecast expressed as:

1. Previous year(s): what the EPS was in the past year(s)

2. Current: what the EPS is this year

3. 1 year: what analysts estimate it will be in one year

4. 2 year: what analysts estimate it will be in two years

The figures used in supporting your analysis are dependent on the intended time frame upon which you would like to trade. E.g. if you are trading short term; the current EPS compared to last years, combined with the outlook for the next year is more relevant to you.

If, however you are trading over the medium to long term, then the two year forecast compared to the current year is much more important.

Keep in mind that a forecast is not a guarantee, and these figures can change.

Therefore it is important you always trade on what you know (and can verify) at the time.

The EPS is calculated by dividing the net income earned in a given reporting period (usually quarterly or annually) by the total number of shares outstanding during the same term. Because the number of shares outstanding can fluctuate, a weighted average is typically used.

For example ABC Corp. reported net income available to shareholders of $5 million.

Over the same time frame, the company had a total of 8 million shares outstanding.

The company’s quarterly earnings per share (or EPS) would amount to $0.40, calculated as follows:

$5 million in earnings divided by 8 million shares = EPS of $0.62

Analysing the current EPS and then comparing it to the forecasted growth will not always mean that the share price will grow by this amount. And just because one company has a higher earnings growth over set period over another doesn’t mean that their growth will be better.

This is why you should always consider all the data available on a company prior to making a decision on whether to purchase shares or not.

The PE Ratio is calculated as:

Market Value of Share
Earnings Per Share

For example, if a company is currently trading at $52 a share and earnings over the last 12 months were $2.30 per share, the P/E ratio for the stock would be 22.6 ($52/$2.30).

Sometimes, a high P/E Ratio suggests that investors are expecting higher earnings growth in the future compared to companies with a lower P/E Ratio

The P/E Ratio is sometimes referred to as the multiple, as it shows how much investors are willing to pay per dollar of earnings. For example if a company were currently trading at a multiple (P/E) of 20, the interpretation is that investors are willing to pay $20 for $1 of earnings.

A low PE ratio (E.g. 10) compared to other stocks in the sector or index can also suggest that the stock is undervalued and a good buy. A high PE Ratio (E.g. 50) can indicate that stock is overvalued and should be sold.

But this method has its limitations because the published PE is based on the previous year’s earnings, which is historical, rather than a projected measure of the performance of the company.

Therefore if we had to make a judgement on this fundamental data alone, it would indicate either to buy or sell the stock. However, because we also take other factors into account, such as the dividend yield and the EPS, we may decide to buy a stock with a high PE or continue to own a stock with a PE below the market average.

These are the major sources of information. One must train oneself to listen and absorb information that is received. One should analyze and interpret the information to determine the profitable course of action to be taken. This is the essential governing principle of fundamental analysis – action only after receiving and analyzing information.

All information is important and can be grouped under the following classifications:

a) Information about the economy.

b) Information about government policy; taxation, levies, duties and others.

c) Information about the industry in which the company operates.

d) Information about the company – its management, its performance, its sales and its products including its performance in relation to other
similar companies.

e) Information about consumer outlook, fashions and spending.
In India we are fortunate that there is greater awareness of the need for information today than ever before and this need is being addressed by the media, researchers and professional investment consultants are addressing that need.

Internet
The internet is a tremendous source of information. It can tell you about the economy, company results, profiles and a host of other information. Now you can even buy and sell shares instantly on the “net”.

Media
There are several investment and business focused magazines, papers and directories that are available today that discuss the economy,
industries and individual companies. These contain articles of a high standard that analyze industries and companies in depth. They also contain knowledgeable articles on tax, investment strategies, finance and allied subjects.  The serious investor should read at least one
good financial paper every day and two magazines a month. This ought to keep him well informed.

Investment Newsletters
There are several professional investment managers and experts who publish investment information. This is extremely useful as they are often very up to date and contain information not generally available to the investor.

Insiders
Insiders are persons who work for a company or who have intimate dealings with a company and have access to, or are aware of information
that is not generally known. This could be information on the performance of the company or rights or bonus issues or some other relevant news. As the information is not known to all, the investor must act fast if he wishes to make a killing. The Securities Exchange Board of India (SEBI) has published regulations prohibiting insider trading.

Seminars and Lectures by investment experts
Excellent seminars and lecture are being held in the country. These are conducted by eminent individuals and one can pick up a lot of information attending these lectures. These may be on how an industry is doing, their view of an industry and the like. One can even share thoughts with those they meet. This can result in forming opinions. Acting on these opinions could be profitable.

Stockbrokers
Stockbrokers are always in touch with companies and are normally aware of their performance and other factors affecting the price of a share.

These are the major sources of information. One must train oneself to listen and absorb information that is received. One should analyze and interpret the information to determine the profitable course of action to be taken. This is the essential governing principle of fundamental analysis – action only after receiving and analyzing information.

It is also extremely important that one acts swiftly on the information received as the person who receives it first will often be the person
to profit most from it.

Explain with Illustration

The share of XYZ Co.costs: Rs 360

Annual dividend: Rs. 10

Dividend yield: 2.77% (10/360)

Historically, a higher dividend yield has been considered to be desirable among investors. A high dividend yield is considered to be evidence that a stock is underpriced, whereas a low dividend yield is considered evidence that the stock is overpriced. A note of caution here though. There have been companies in the past, which had a record of high dividend yield, only to go bust in later years. Dividend yield therefore can be only one of the factors in determining future performance of a company.

• Growth in the value (market price) of the share
• Dividends

Dividend is distribution of part of a company’s earnings to shareholders, usually twice a year in the form of a final dividend and an interim dividend. Dividend is therefore a source of income for the shareholder. Normally, the dividend is expressed on a ‘per share’ basis, for instance – Rs. 3 per share. This makes it easy to see how much of the company’s profits are being paid out, and how much are being retained by the company to plough back into the business. So a company that has earnings per share in the year of Rs. 6 and pays out Rs. 3 per share as a dividend is passing half of its profits on to shareholders and retaining the other half. Directors of a company have discretion as to how much of a dividend to declare or whether they should pay any dividend at all.

The three broad types of price risks are:

(a) Market Risk: Market risk arises when security prices go up due to reasons affecting the sentiments of the whole market. Market risk is also referred to as ’systematic risk’ since it cannot be diversified away because the stock market as a whole may go up or down from time to time.

(b) Interest rate risk: This risk arises in the case of fixed income securities, such as treasury bills, government securities, and bonds, whose market price could fluctuate heavily if interest rates change. For example, the market price of fixed income securities could fall if the interest rate shot up.

(c) Rxchange rate risk: In the case of imports, exports, foreign loans or investments, foreign currency is involved which gives rise to exchange rate risk.

To hedge these risks, equity derivatives, interest rate derivatives, and currency derivatives have emerged.

1400s                                          Japanese rice futures

1600s                                         Dutch tulip bulb options

1800s                                         Puts and options

The Recent Financial Derivatives Listed Markets

1972                                         Financial currency futures

!973                                          Stock options

1977                                        Treasury bond futures

1981                                         Euro dollar futures

1982                                         Index futures

1983                                        Stock index options

1990                                       Foreign index warrants and leaps

1991                                        Swap futures

1992                                       Insurance futures

1993                                        Flex options

OTC Markets

1981                                     Currency swaps

1982                                     Interest rate swaps

1983                                     Currency and bond options

1987                                    Equity derivatives markets

1988                                     Hybrid derivatives

Derivatives include:

(i) a security derived from a debt instrument, share, loan (whether secured or unsecured), risk instrument, or contract for differences, or any other form of security.

(ii) a contract which derives its value  from the prices or index of prices of underlying securities.

To understand the meaning of derivatives, let us take example of a commodity such as cotton, which is the raw material for the textile industry. It may so happen that the price of cotton arises before and after the harvest but falls at the time of harvest. The farmer, who is exposed to such price fluctuations, can eliminate this risk by selling his harvest at a future date by entering into a forward, or futures contract. This forward, or futures, contract takes place in the ‘derivatives’ market. The prices in the in the derivatives market are driven by the spot or cash market of the underlying asset, which is cotton in this example.

The market for financial derivatives has grown tremendously both in terms of variety of instruments and turnover. Derivatives can be futures, options, swaps, forwards, puts, calls, index-linked and so on.  in financial derivatives, the underlying includes treasuries, bonds, stocks, stock index, foreign exchange, and euro-dollar deposits.

The Japanese began using technical analysis to trade rice in the 17th century. While this early version of technical analysis was different from the US version initiated by Charles Dow around 1900, many of the guiding principles were very similar:

• The “what” (price action) is more important than the “why” (news, earnings, and so on).

• All known information is reflected in the price.

• Buyers and sellers move markets based on expectations and emotions (fear and greed).

• Markets fluctuate.

• The actual price may not reflect the underlying value.

According to Steve Nison, candlestick charting first appeared sometime after 1850. Much of the credit for candlestick development and charting goes to a legendary rice trader named Homma from the town of Sakata. It is likely that his original ideas were modified and refined over many years of trading eventually resulting in the system of candlestick charting that we use today.

In order to create a candlestick chart, you must have a data set that contains open, high, low and close values for each time period you want to display. The hollow or filled portion of the candlestick is called “the body” (also referred to as “the real body”). The long thin lines above and below the body represent the high/low range and are called “shadows” (also referred to as “wicks” and “tails”). The high is marked by the top of the upper shadow and the low by the bottom of the lower shadow. If the stock closes higher than its opening price, a hollow candlestick is drawn with the bottom of the body representing the opening price and the top of the body representing the closing price. If the stock closes lower than its opening price, a filled candlestick is drawn with the top of the body representing the opening price and the bottom of the body representing the closing price.

Compared to traditional bar charts, many traders consider candlestick charts more visually appealing and easier to interpret. Each candlestick provides an easy-to-decipher picture of price action. Immediately a trader can see compare the relationship between the open and close as well as the high and low. The relationship between the open and close is considered vital information and forms the essence of candlesticks. Hollow candlesticks, where the close is greater than the open, indicate buying pressure. Filled candlesticks, where the close is less than the open, indicate selling pressure.

The concept of SUPPORT AND RESISTANCE is essential to understanding and interpreting the markets. Just as a ball bounces when it hits the floor or drops after being thrown to the ceiling, support and resistance define natural boundaries for rising and falling prices.

Buyers and sellers are constantly in battle mode. Support defines that level where buyers are strong enough to keep price from falling further. Resistance defines that level where sellers are too strong to allow price to rise further. Support and resistance play different roles in uptrends and downtrends. In an uptrend, support is where a pullback from a rally should end. In a downtrend, resistance is where a pullback from a decline should end.

Support and resistance are created because price has memory. Those prices where significant buyers or sellers entered the market in the past will tend to generate a similar mix of participants when price again returns to that level.

When price pushes above resistance, it becomes a new support level. When price falls below support, that level becomes resistance. When a level of support or resistance is penetrated, price tends to thrust forward sharply as the crowd notices the BREAKOUT and jumps in to buy or sell. When a level is penetrated but does not attract a crowd of buyers or sellers, it often falls back below the old support or resistance. This failure is known as a FALSE BREAKOUT.

Support and resistance come in all varieties and strengths. They most often manifest as horizontal price levels. The length of time that a support or resistance level exists determines the strength or weakness of that level. The strength or weakness determines how much buying or selling interest will be required to break the level. Also, the greater volume traded at any level, the stronger that level will be.

Support and resistance exist in all time frames and all markets. Levels in longer time frames are stronger than those in shorter time frames.

Support and resistance represent key junctures where the forces of supply and demand meet. In the financial markets, prices are driven by excessive supply (down) and demand (up). Supply is synonymous with bearish, bears and selling. Demand is synonymous with bullish, bulls and buying. As demand increases, prices advance and as supply increases, prices decline. When supply and demand are equal, prices move sideways as bulls and bears slug it out for control.

What is Support?

Support is the price level at which demand is thought to be strong enough to prevent the price from declining further. The logic dictates that as the price declines towards support and gets cheaper, buyers become more inclined to buy and sellers become less inclined to sell. By the time the price reaches the support level, it is believed that demand will overcome supply and prevent the price from falling below support.

After a support level is penetrated, it often becomes a resistance level; this is because investors want to limit their losses and will sell later, when prices approach the former level.

What is Resistance?

Resistance is the price level at which selling is thought to be strong enough to prevent the price from rising further. The logic dictates that as the price advances towards resistance, sellers become more inclined to sell and buyers become less inclined to buy. By the time the price reaches the resistance level, it is believed that supply will overcome demand and prevent the price from rising above resistance.

After a resistance level is penetrated, it often becomes a support level; this is because buyers who didn’t buy at that price before it went up are now willing to buy at that price.

In practice, however, it is observed that the market prices often deviate significantly from the fundamental. This is because many of the assumptions made in assessing the fundamental value of a share may not obtain reality. Further, for reasons of temporary imbalances in the demand and supply of securities, money, market moods, economic conditions, corporate performance, speculation, labour conditions, insider trading and a host of other reasons, the actual prices of securities may take long excursions from their fudamental.

The fundamental analysts, however, believe that any identifying and processing relevant information ‘correctly’ and quickly (as compared to the market as a whole), they can predict the share price movements faster than the market, and gain that short-lived edge over others which they can capitalize upon, and thus out-perform the market. However, there is no conclusive evidence, either in India or elsewhere, that fundamental analysis out-perform any randomly selected well diversified portfolio over a long investment horizon.

Also, it must be mentioned that the use of fundamental approach in estimating the returns from a security is at best an art, notwithstanding all its number crunching. To begin with, the approach has to be used in cofunction with one’s own knowledge, experience and assessment of the firm, the industry, as well as that of the economy as a whole. Even when the historic data is being used, the selection of periods, prices and averaging processes can introduce considerable differences in the computations.

Fundamental analysis is the examination of the underlying forces that affect the well being of the economy, industry groups, and companies. As with most analysis, the goal is to derive a forecast and profit from future price movements. At the company level, fundamental analysis may involve examination of financial data, management, business concept and competition. At the industry level, there might be an examination of supply and demand forces for the products offered. For the national economy, fundamental analysis might focus on economic data to assess the present and future growth of the economy. To forecast future stock prices, fundamental analysis combines economic, industry, and company analysis to derive a stock’s current fair value and forecast future value. If fair value is not equal to the current stock price, fundamental analysts believe that the stock is either over or under valued and the market price will ultimately gravitate towards fair value. Fundamentalists do not heed the advice of the random walkers and believe that markets are weak-form efficient. By believing that prices do not accurately reflect all available information, fundamental analysts look to capitalize on perceived price discrepancies.

Fundamental analysis submits that no one should purchase a share on a whim. Investment in shares is serious business and all aspects and factors, however minor, must be analyzed and considered. The billionaire Jean Paul Getty, until his death the richest man in the world, once said, “No one should buy without knowing as much as possible about the company that issues it”. Jim Slater was one of the most successful stock pickers of all time. He evolved a theory called the Zulu theory which submits that one must know all about the company and the industry and any other factor that may affect the company’s performance. His argument was that one could never lose if one has this information. If the company is likely to do badly, one can sell and then buy shares to cover this when the price falls, and vice versa. This is the philosophy of professional and successful investors – informed investing. And this is the foremost tenet of fundamental analysis. As Adam Smith says, “There is no substitute for information. The market is not a roulette wheel. Good research and good ideas are the one absolute necessity in the market place.”

There are three things that you need to know when it comes to the fundamentals of a company, which are:

1. Dividend Yield of the company
2. Price Earnings Ratio (PE ratio)
3. Earnings Per Share (EPS)

Fundamental Analysis tries to measure the intrinsic value of a stock by going through its financial, economic, quantitative and qualitative factors. It also considers the macroeconomic factors (both domestic and international) that could have an effect on the value of the stock . Some of the company or industry specific factors are Sales figure of the company (Quarterly, Yearly, etc.), Earnings of the Company, Assets and Liabilities of the Company, Management Efficiency of the Company, Company’s competitive position among its industry rivals. Fundamental Analyst s rely on the balance sheets of the company for arriving at its book value. This helps them to compare the actual value of the stock in the secondary market with that of the book value in order to evaluate whether the stock is overvalued or not. When the Market Value of a stock exceeds its Face or Intrinsic value then it signifies that the expectations of the investors are higher than the real value of the company. Hence, a correction in its price is evident. Fundamental Analysis studies the fundamental strength of the company which is effective in gauging the long run scenario of the stock price rather than the short run fluctuations.

Fundamental Analyst look at the following aspects for judging the fundamental strength of the company :-

1. Balance Sheet:Financial position of a company is reflected through its Balance Sheet where the detailed numerical of the assets and liabilities are recorded. It is always desirable for a company to have Assets and Liabilities reflects its sound financial condition.

2. Return on Assets:It measures the profitability of a company. This shows the company’s strength from the long term perspective and is a good indicator for the long term investors.

Return on Assets = (Net Income of the company for the last 1 year) / (Total Asset of the Company)

3.  Net Income: Revenue of a company comprises of income from the sales of its products, and other incomes. Cost of a company comprises operation costs, servicing of depreciation, interest payments, etc. Another business and economic jargon for Net Income is Bottom Line.

Net Income =(Total Revenue of the Company) – (Total Cost to the Company)

4. Revenue: Revenue of a company comprises its income from sales of its products, and other associated incomes. It indicates the demand scenario of the company’s products which are also an indicator of its growth.

5. Cash Flow: Liquidity Position of the company can be gauged by analyzing this tool. Hence, Fundamental Analysis is a part of the Stock Market Analysis which uses the fundamental aspects of the companies and the economy for predicting the future direction of the stock in particular and the economy in general.

Cash Flow of a Company (for a particular period of time) = (Cash Receipts of a Company) – (Cash Payments of the Company)

In other words, Technical Analysis is the forecasting of future financial price movements based on an examination of past price movements. Like weather forecasting, technical analysis does not result in absolute predictions about the future. Instead, technical analysis can help investors anticipate what is “likely” to happen to prices over time. Technical analysis uses a wide variety of charts that show price over time.

Technical analysis is applicable to stocks, indices, commodities, futures or any tradable instrument where the price is influenced by the forces of supply and demand. Price refers to any combination of the open, high, low, or close for a given security over a specific time frame. The time frame can be based on intraday (1-minute, 5-minutes, 10-minutes, 15-minutes, 30-minutes or hourly), daily, weekly or monthly price data and last a few hours or many years. In addition, some technical analysts include volume or open interest figures with their study of price action.

THE BASIS OF TECHNICAL ANALYSIS

Price Discounts Everything

Prices Movements are not Totally Random

Most technicians agree that prices trend. However, most technicians also acknowledge that there are periods when prices do not trend. If prices were always random, it would be extremely difficult to make money using technical analysis.

“What” is More Important than “Why”