Fundamental analysis and technical analysis are two of the main ways investors and traders determine which stocks or other assets to buy or sell. Fundamental analysis looks at a company's financial health to try to determine its future prospects, while technical analysis looks for patterns in the way a security has traded in the past in order to try to estimate how it will move in the future.
Essentially, investors look at a company's fundamentals to determine whether it's worth buying or not, while technical analysis is used to determine when is the best time to buy or sell it.
While fundamentalists argue that a company's finances and future growth prospects are the most important determinants in a company's valuation, technical analysts argue that the stock market doesn't always value a company fairly or accurately. Instead, they look at a company's trading history—both in terms of prices and trading volume—to determine whether they should buy or sell, and when.
Fundamental analysis looks at quantitative ratios and statistics of a business to determine its financial health, including:
- Profitability (i.e., earnings per share)
- Price to earnings (PE) ratio
- Sales revenue
- Projected earnings growth (PEG ratio)
- Growth prospects
- Dividend yield
- Dividend payout ratio
- Dividend growth rate
- Return on equity (ROE) ratio
- Cash flow
It also considers more qualitative issues, such as:
- Quality of management
- Products and services
- Competitive position
- Legal issues
Drawbacks Of Fundamental Analysis
While all the above information is important and may be completely accurate, companies that are fundamentally strong are not always rewarded by the marketplace. For example, certain types of companies may be out of favor in the general marketplace and their price may not reflect their actual strength, sometimes for long periods of time. For example, fast-growing companies with no profits may have higher valuations and perform better than older, more solid companies with high dividends. At other times, the opposite is true.
Fundamental analysis also cannot predict any kind of a surprise event, such as the unexpected death or resignation of a key executive, a sharp drop in sales, a new competitor, a lawsuit, or something similar.
Technical analysts, on the other hand, believe that supply and demand (i.e. investor sentiment) for a particular stock is more important in determining the price of the stock at any given moment. Indeed, they spend little time looking at a company's fundamentals, believing that all of the available information about a company is already widely known and reflected in the price.
Instead, they believe that by looking at a chart of the past trading activity of a stock—reflecting both price changes and trading volume—it's possible to discern and predict its future movements. They believe that trading patterns—like the ups and downs in a particular stock – often repeat themselves over time and that investors should buy and sell in anticipation of a similar move in the future if the chart signals such a move.
Technical analysis can also be used to study trading activity in bond prices and interest rates, commodities, futures and the like. Basically, you can use it to study the activity of any security or benchmark that is influenced by supply and demand. Charts can track trading activity in very small intervals or over long periods.
Drawbacks Of Technical Analysis
Just as two doctors or medical technicians can interpret an X-ray differently, two technical analysts—also known as technicians—can come to different conclusions looking at the same trading chart.
For example, one analyst may perceive an uptick in a stock as a signal of a more pronounced upward movement, while another may believe it is a false signal. Indeed, technical analysis if often is perceived to be more of an art than a science, whereas fundamental analysis deals with hard numbers. This leads to another drawback of technical analysis, namely that a chart only shows something after it happens. At this point, it's often too late to do anything about it.
Technical analysis also smacks of market timing, which many investment professionals strongly advise against because no one can predict the future. As a result, fundamental analysis is more suitable for investors with a long-term horizon, while technical analysis is best left to traders or investors with a short-term outlook.
Fundamental and technical analysis are two of the main tools investors and traders use to make investment decisions. Fundamentals are the actual numbers—profits, revenue, dividends, etc.—that measure the financial health of a company and to estimate its future prospects.
Technical analysis, by contrast, largely eschews those figures and looks solely at the trading behavior of a specific security in the belief that past patterns are duplicated over time and can be used to estimate the security's next move. Fundamental analysis is better used as a tool for long-term investing, while technical analysis is more appropriate for traders and those with a short-term horizon.