Every investment should be preceded by a proper analysis aimed at minimizing possible risk and maximizing potential profits. Learn about the two most popular analysis methods that will help make the investment selection process more thoughtful and facilitate the choice of assets worth investing in.
What is fundamental analysis?
The simplest definition of fundamental analysis describes it as an analysis based on the state of the economy or a company. It consists of five stages, which are explained in more detail below. Usually used for long-term investing, therefore these stages are recommended for investors who plan to invest funds during this time period.
5 stages of fundamental analysis
- Macroeconomic analysis – Pertaining to assessing the attractiveness of a particular financial market. In doing so, one must take into account the political situation in a particular country, the general economic situation and economic factors such as exchange rates, inflation, national income, budget or employment-to-unemployment ratio.
- Sector analysis – At this stage, a decision is made to invest in a particular economic sector and monitoring of the relevant companies begins. It’s about checking which industry offers the best investment opportunities. According to the development trend of the industry and the changes in the national income generated compared with other industries, the potential risks and opportunities of enterprise investment in this industry can be evaluated.
- Situational analysis – In this phase, a specific company within a specific industry is analyzed. In other words, it’s about defining how a particular company is performing compared to the industry as a whole and where it stands in the market. Examples that should be considered include practical information such as: given the company’s immediate goals, identifying its business profile and defining its strengths, weaknesses, opportunities it creates, and threats its business profile poses. Last four factors create an auxiliary analysis called SWOT (Acronym for Strengths, Weaknesses, Opportunities, Threats).
- Financial analysis – One must not forget that, at the end of the day, investing is primarily about making a profit. In short, financial analysis should help determine a company’s current value and its ability to generate future profits. The basic approach here is to examine three financial reports: Profit and Loss Statement (revenue generated by the company during a certain period of operation and costs incurred by the company during a certain period of operation and the final financial results), cash flow (recording the company’s internal cash flow, including income and expenses, and how the company manages its money) and balance sheet (the economic condition of the company at a specific point in time, including assets and liabilities).
- Stock valuation – Before investing in any company, it is easier to make the final decision by determining the intrinsic value of the stock. Since there are different sources of income based on owning stocks, one should consider dividend levels, price changes in stocks, etc. during a particular period. Before determining the intrinsic value of the stock, the company’s expected future profits should be discounted. This determines its current value, while the sum of the discounted returns from owning the stock determines the intrinsic value of the stock.
What is technical analysis?
The simplest term to describe technical analysis is analysis based on information available on price charts. The analysis is based on three pillars, described below. Fundamental analysis answers the question “what to invest in?” while technical analysis answers the question “when should one invest?” The above pillars are:
- The market discounts everything – This pillar assumes that there is no need to study what affects the price of an instrument or to study why prices fall or rise. Why? Since price action reflects changes in supply and demand conditions, all factors that affect price have been included here. It is based on the belief that market price levels are correlated with all available information about a particular instrument, its issuer (e.g. good financial performance) and economic and political conditions or micro and macroeconomic conditions (examples here are central bank decisions, economic growth indicators, inflation or unemployment). Asset prices immediately adjust to any new information that appears to reflect the latest state.
- Prices move in trends – Under this assumption, the price of an asset moves in a specific direction over a specific period of time. This situation is called a trend. By spotting trends, one can determine which trade (buy or sell) is the most profitable. It must be remembered, however, that there are many variables that determine whether the trend will continue or reverse.
- History repeats itself – During chart analysis, repeating patterns can be found. Because of the fact that in specific situations human behaviors are a subject of repetition, studying past trends can be used to foresee future behaviors. That’s why collective behavior of the investors on a given market repeats according to specific schemes.
Fundamental analysis is based on examining the condition of economics and companies, focusing on macroeconomic, sector, situational, or financial factors. Technical analysis on the other hand is focused on price charts, including such assumptions as: the market includes all available information, prices are trended, and that history repeats itself. Both analyses are important tools during the selection of assets and making investment decisions. Which one will work better depends on individual investment plans.
Combination of both analyses
If an investor is unsure what kind of analysis to choose, it’s possible to consider both of them. Some companies can turn out to be a good investment after combining elements of both techniques. This method starts with initial selection of companies that meet such fundamental analysis criteria as annual revenue growth rate or dividend rate, and then analyzing the information coming from their price chart, based on the pillars mentioned earlier.
Examples given in this article are only an approximation of a scheme that can be used while making investment decisions. Regardless of what type of analysis is chosen, a key to make it helpful in any way is its reliable execution.